Segment 1 Of 4 Next Hearing Segment(2)
SPEAKERS CONTENTS INSERTS
Page 1 TOP OF DOC Segment 1 Of 4 REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION
TUESDAY, MAY 18, 1999
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
The subcommittee met, pursuant to notice, at 3:05 p.m., in room 1301, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Barrett, Smith, Everett, Chambliss, Moran, Thune, Jenkins, Gutknecht, Simpson, Ose, Hayes, Dooley, Pomeroy, Baldacci, Goode, McIntyre, Etheridge, John, Boswell, Lucas of Kentucky, Thompson, and Stenholm [ex officio].
Staff present: Lance Kotschwar, chief counsel; Dave Ebersole, senior professional staff; Stacy Carey, subcommittee staff director; Greg Zerzan, Ryan Weston, and Wanda Worsham, clerk.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. The subcommittee meeting on Risk Management, Research, and Specialty Crops to review the Commodity Futures Trading Commission reauthorization will come to order.
I want to welcome everyone here today to the first in a series of hearings that began with the House Agriculture Committee's reauthorization of the Commodity Futures Trading Commission. This week's discussion will serve as the committee's benchmark hearing for the reauthorization debate.
Page 2 PREV PAGE TOP OF DOC Segment 1 Of 4 We are here today to solicit your views and observations on the many issues before us. I believe we need to ask ourselves two fundamental questions as we sort through this process: How will our markets evolve over the next 10 to 15 years? And is our regulatory structure able to accommodate current challenges and those that lay ahead? The core issue for this committee's consideration is the Commodity Exchange Act structured in a way that will accommodate evolution of markets, foster innovation, allow competition, and preserve market integrity. Some may argue the act as written meets these goals. Others argue that the act requires modernization.
The earliest forefather of the Commodity Exchange Act, the Grain Futures Act of 1922, relied primarily on exchange self-governance, subject to Government oversight. Today's regulatory structure relies on the same framework. The relevant question here is does today's Commodity Exchange Act preserve an equitable balance between self-governance and Government oversight?
Other questions are equally important to this debate: The role technology has in the market evolution? Are the U.S. markets able to remain competitive in the global marketplace? Are U.S. securities and future exchanges prepared to meet these challenges? Underlying these general questions are technical issues, such as the treatment of futures and derivative products under the current regulatory structure.
Markets require a level of legal certainty if they are to operate efficiently. The reauthorization process should by no means increase legal uncertainty for swaps and other derivatives. Treatment of the Treasury amendment products under the Commodity Exchange Act requires our consideration. How can transactions in foreign currencies and Government securities, among others, remain exempt from the act while affording investment broad protection to retail customers?
The Shad-Johnson Accord also needs examination. The accord negotiated between the SEC and the CFTC in 1981 addresses jurisdiction over securities-based derivatives. Should it be preserved or should it be repealed? The Chicago Futures Exchanges believe it should be repealed to allow future trading on narrow based indices and on single stocks. However, the Securities Exchange believes the Shad-Johnson Accord should be preserved.
Page 3 PREV PAGE TOP OF DOC Segment 1 Of 4 Many of these issues have been on Congress's radar screen for quite awhile. I might add they have come to us nicely packaged with a rich history of contentiousness. This will be the second authorization to occur under my chairmanship and that's a hopeful sign. Although I am under no illusions that the 2000 reauthorization process will be simple as the 1995 reauthorization, I'm proud to begin this process with great optimism as the committee prepares to sort through many diverse views, thoughts, and ideas.
Given the enormous task before us, I would like to take the liberty of outlining basic guideline principles that I believe, if followed, will make for a successful reauthorization process. It will be important for each of us to create and maintain the cooperative process through open dialogue, focus on maintaining and fostering the competitiveness of the U.S. markets; and encourage regulatory efficiency and maintain market integrity. Whatever we end up through this journey, if we have followed these principles, I believe our efforts will be successful.
And, again, welcome to today's hearing, and I look forward to your testimony.
A little on the process, which is certainly not different: We intend to take summaries of your statements. We hope that you will summarize your statement and abide by the 5-minute rule, so we will have as much time for questioning. I do want to extend the apologies of Ranking Member Gary Condit, who missed his plane from California and that's just a little more than a hop, skip, and a jump.
Because of the change in the schedule of the House, I appreciate your willingness to accommodate us and move this hearing to this afternoon so we could have more Members present. The Friday hearing, which had to be canceled again because of the House schedule, will be rescheduled for June 8 at 1:00 p.m. in this room.
I would also indicate that several groups have submitted written statements for the record: the Futures Commission Merchant Coalition for Regulatory Fairness; American Cotton Shippers Association, and Champion Securities.
Page 4 PREV PAGE TOP OF DOC Segment 1 Of 4 And with that, I will go to the ranking member of the full committee, Mr. Stenholm, for any comments he may have.
Mr. STENHOLM. Thank you, Mr. Chairman. I have an opening statement that I would like to have inserted in the record at this point and also I will be submitting some questions in writing concerning the oil industry to the panel at a later date. I will not be able to be here for the questioning, but I will be submitting written questions. Thank you, Mr. Chairman.
[The prepared statement of Mr. Stenholm follows:]
PREPARED STATEMENT OF HON. CHARLES W. STENHOLM, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. Chairman, I want to commend you, Ranking Minority Member Condit, and the members of the subcommittee for convening hearings regarding the Commodity Exchange Act. I believe the witnesses you have assembled will provide the perspective needed to kick-off the efforts of our committee to update the act.
It has been nearly 7 years since substantial modifications were made to the CEA. The 1992 legislation made important improvements which have fostered the continued growth and development of our Nation's derivatives industry, while ensuring the type of market and consumer protection that has led to the tremendous confidence that investors worldwide have demonstrated in our markets.
Trading in financial derivatives contracts has grown dramatically in recent years. Two hundred and ninety million futures contracts were traded on regulated futures exchanges in the United States in 1992.
In 1998, the number rose to over 500 million contracts. Of those, 350 million were related to financial instruments such as interest rates, stock indexes, and foreign currencies.
Page 5 PREV PAGE TOP OF DOC Segment 1 Of 4 Trading in options on futures contracts has experienced similar growth. U.S. securities option exchanges reported volume of 406 million contracts in 1998 compared to 204 million in 1992.
Even more dramatic growth has occurred in the trading of over-the-counter derivatives such as swaps. The International Swaps and Derivatives Association reports that the global notional principal of interest rate swaps, currency swaps, and interest rate options outstanding at the end of 1992 was $5.3 trillion. As of the end of 1998, that total had grown to $5 1 trillion. U.S. commercial banks held OTC derivative positions with a notional value of $22 trillion at the end of 1998, compared to $4 trillion at the end of 1992. These statistics generally show that derivatives markets are healthy, available, and delivering what their customers want. Each offers investors the opportunity to take on or lay off risk, and the activity level implies a high level of trust in the markets.
During this Congress, we have the opportunity to continue the progress we made in 1992. Derivatives regulation is a complex area. We need lots of input and lots of consensus. It is encouraging that the regulators who make up the President's Working Group on Financial Markets are working closely together on a comprehensive derivatives framework. Private industry talks are also proceeding in a constructive way.
Mr. Chairman, I am confident that consensus products from these forums can be implemented through legislation as long as the views and interests of end-users are considered throughout. While financial derivatives have long-overtaken agricultural, energy, and other physical derivatives in terms of exchange-trading volume, physical market futures will continue to serve as extremely important tools for price discovery and risk-shifting. The CFTC and self regulatory organizations must continue to have sufficient resources and the authority to protect the integrity of the markets.
Recent dramatic swings in crude oil prices have been accompanied by broadening expressions of distrust in oil futures trading. Our system requires that we continue to ask threshold questions about the quality of our markets:
Page 6 PREV PAGE TOP OF DOC Segment 1 Of 4 In the case of oil, was the degree of reduction in price displayed November 1998 on the exchange consistent with the market's fundamentals?
Are speculative interests causing oil trading to occur at artificial price levels?
Are there further improvements to Federal regulations and exchange rules that will improve public confidence in the fairness and integrity of energy futures markets?
Are reporting requirements sufficient and observed?
Is the information obtained utilized effectively?
While these questions are current in the minds of oil producers who are experiencing difficult economic times, they apply as well to all markets which underlie derivatives trading. A comprehensive review of our policies requires that we see that they are answered.
Mr. Chairman, there are other areas that I am sure we will address in the course of our legislative effort. We will be called upon to:
Provide legal certainty to the OTC derivatives industry.
Lighten the overall regulatory burden on our Nation's exchanges.
Do all we can to achieve parity of regulation for domestic exchanges with respect to the OTC market and with respect to foreign exchanges, all the while ensuring that the system we end with serves to preserve the strength, fairness, and efficiency of our financial services industry.
Mr. Chairman, I look forward to working with you and all members of the committee in this endeavor and I thank you once again for holding this week's hearings.
Mr. EWING. Thank you. Any other statements by Members may be included at this time.
Page 7 PREV PAGE TOP OF DOC Segment 1 Of 4 [The prepared statements of Members follow:]
PREPARED STATEMENT OF HON. BILL BARRETT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NEBRASKA
Thank you, Mr. Chairman, for holding this hearing to review the reauthorization of the Commodity Futures Trading Commission. I commend the chairman for his leadership on this issue. I would also like to thank our witness panel for their participation in this hearing.
The Commodity Futures Trading Commission is critical to our Nation's farmers during this time of low commodity prices. It is very important that the Committee on Agriculture continues to carefully review each aspect of this CFTC reauthorization. We must work together to present society with an agency that discourages fraud and manipulation, but encourages technology, competition and a sound business environment.
Mr. Chairman, as you know, our producers are becoming more involved in futures markets with each passing crop year. I have farmers in Nebraska that study futures prices each morning before they leave for the fields. I try to encourage the use of the futures market to allow producers with yet another valuable risk tool. As we review each issue, it is essential that we keep a producer viewpoint in mind. I believe that this subcommittee will conduct a serious investigation of Over-the-Counter Derivatives and Agriculture Trade Options.
Once this reauthorization is complete, I expect the CFTC to regulate the U.S. futures and related markets and protect the interests of those who use the markets.
I look forward to hearing testimony from each witness here today.
PREPARED STATEMENT OF HON. NICK SMITH, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MICHIGAN
I would like to thank the chairman for holding this important hearing on reauthorization of the Commodity Futures Trading Commission.
Congress will be considering various issues in the CFTC reauthorization, including regulatory authority, reducing legal risk, defining the CFTC's role in the OTC market, and the regulation of foreign terminals in the United States. All of these issues are important and will be addressed. However, we must not lose focus of the importance of agriculture as we consider changes. As commodity prices continue to fall, and markets decline overseas, we must make
Page 8 PREV PAGE TOP OF DOC Segment 1 Of 4 more concerted effort to accommodate farmers with assured accuracy of price disclosure and reasonably priced hedging opportunities. We should provide further incentives to farmers to encourage them to use the futures market to manage and reduce the risks that they face. The fact that there have been no participants in the OTC pilot program which was authorized in 1998 is a clear indication that we need to provide better information and perhaps fix their incentive for participation. In some areas there should be more flexibility and in other areas there should be better oversight by the CFTC.
I look forward to hearing from the witnesses on this important subject.
PREPARED STATEMENT OF HON. GARY A. CONDIT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF CALIFORNIA
Mr. Chairman, thank you for holding this important series of hearings regarding the reauthorization of the Commodity Exchange Act. Our subcommittee has the opportunity this Congress to make improvements in our futures regulatory statute that tailor its protections to the rapidly changing marketplace. While this task will be challenging, hearings such as those we have this week will provide invaluable background for the work ahead.
Mr. Chairman, with the expiration of her term as chairperson at the Commodity Futures Trading Commission, Ms. Brooksley Born will be departing her position shortly. I believe it is fortunate for us that she has the opportunity to make a final appearance before the subcommittee at this important and pivotal time for the financial services industry. She has executed her responsibilities with tremendous dedication and thoughtfulness and I am grateful for the service that she has committed to the public interest. I am sure that as we proceed in the months ahead to develop legislative improvements to the act, the perspectives Chairperson Born leaves us today will provide useful background.
I appreciate the fact that you have invited each of the Commissioners to testify today as well as representatives of the Treasury Department, the Board of Governors of the Federal Reserve System, and the Securities and Exchange Commission. There are many sides to the issues that we must address and our only hope of developing comprehensive improvements is to encourage all parties to engage in an open discussion. I am grateful for the appearance of each of our witnesses today.
Page 9 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. Chairman, with the number of controversies that have erupted in recent years over interpretation and implementation of the CEA, it would be easy to conclude that the act is a failure. The actual experience of the derivatives industry in our Nation would lead to the opposite conclusion. Derivatives trading volumeboth on and off of exchangescontinues to climb with trading records set year after year. These high levels of activity show that financial innovation is thriving and that market users have a high level of confidence in the efficiency and fairness of the markets.
Nonetheless, industry actors are seeking improvements in the act. The over-the-counter derivatives industry would have us build on our 1992 efforts to clarify the reach of the CEA. In the face of growing foreign exchange competition, technological innovation throughout the financial services industry, and competition from the OTC industry, the exchanges are seeking modernization of regulations that constrain them.
Mr. Chairman, it is a very hopeful sign that our financial regulatorsthrough the President's Working Group on Financial Marketsare engaged in dialog towards the development of a common view on derivatives policy. Given the turf fights that have dominated in the past, I am very pleased at this level of cooperation. As long as our regulators are able to arrive at a common framework, I have tremendous confidence in our ability to adopt productive improvements to the act.
It is likewise encouraging that representatives of private industry are holding discussions with respect to recommendations they may be able to make in common to Congress and to the regulators. I hope these efforts will proceed and that parties to the discussion will dedicate themselves to their success. I also strongly encourage that entities representative of market end-usersincluding those representing agriculture be drawn into these discussions as soon as possible. The meetings already are quite inclusive. Once the element of the end-user is added, I believe that any recommendations from that forum will have tremendous credibility in Congress.
Page 10 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. Chairman, once again I thank you for convening these hearings and I look forward to the testimony of all of our witnesses.
PREPARED STATEMENT OF HON. DEBBIE STABENOW, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MICHIGAN
Today marks the beginning of a comprehensive, 3-day public hearing on the reauthorization of the Commodity Futures Trading Commission. This subcommittee does not hold very many 3-day hearings. Our extended attention to this issue speaks to its complicated nature and to our intent to thoughtfully consider the details. I look forward to gathering the opinions and technical expertise from the impressive list of witnesses.
For the next 3 days, our subcommittee should explore a number of important public policy questions. First and foremost, we must consider the future of the CFTC in a changing world. Financial and investment products are changing, along with technology, at a rapid-fire pace and the regulatory scheme Congress develops should reflect those changes. Determining what should and shouldn't be subject to CFTC regulation must be evaluated against criteria that considers: consumer protection, global competitiveness and market growth, market integrity, and financial stability.
There are other elements of the regulatory framework that may no longer be necessary. I would like to hear from our panels whether or not they see a continued need for the Shad-Johnson Accord and whether the Treasury amendment needs to be redefined. Certainly this subcommittee should also address the Agricultural Trade Options Pilot Program. Why has no one applied to the pilot program? What changes need to be made to encourage more participation?
Finally, I understand that the industry has taken the initiative and has been meeting on their own to resolve these issues. I would appreciate an update on the status of these discussions. I would also like to commend the spirit of cooperation that is present at today's hearing and that is evident by the industry discussions. I am confident that this spirit will continue and that reauthorization will be a successful endeavor.
Page 11 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. We will proceed to our first panel. And it's with some sadness, Brooksley, that we have you here for this panel today, as I understand this may be your last appearance before our subcommittee. It has been a good run. I have enjoyed working with you. And so we are glad to have the Honorable Brooksley Born, Chairperson of the Commodity Futures Trading Commission; the Honorable Barbara Pedersen Holum, Commissioner; the Honorable David D. Spears, Commissioner; and the Honorable James E. Newsome, Commissioner. Thank you all, ladies and gentlemen, for being here. And we'll start with you, Ms. Born.
STATEMENT OF BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION
Ms. BORN. Thank you very much, Mr. Chairman and members of the subcommittee. I'm pleased to be with you this afternoon to testify concerning issues that Congress should consider as it begins the process of reauthorization of the Commodity Futures Trading Commission or CFTC. I request that my written testimony be entered into the record of this hearing. And before I summarize my testimony, on a personal note, I would like to say that this is my last appearance as chairperson before this subcommittee. My last day in office will be two weeks from today, June 1. I have very much enjoyed working with you, Mr. Chairman, and the other members of the subcommittee and have very appreciated the courtesy and confidence you have shown.
Mr. EWING. Thank you and your statement will be submitted for the record, as all the Commissioners' will be.
Ms. BORN. Thank you very much.
The President's Working Group on Financial Markets, which consists of the Secretary of the Treasury and the Chairs of the Federal Reserve Board of Governors, the Securities and Exchange Commission and the SEC is currently working on a study related to the over-the-counter, or OTC derivatives market, and has just completed a study of hedge funds and other highly leveraged institutions, which it sent up to Congress about three weeks ago. These studies should be a valuable resource for this subcommittee during CFTC reauthorization.
Page 12 PREV PAGE TOP OF DOC Segment 1 Of 4 As a member of the President's Working Group, I'm very pleased to endorse the recommendations contained in its recent report on hedge funds. The report identifies as a central issue excessive leverage in the financial system and the lack of available information about it. The report provides important recommendations about each of the four main issues raised by the near insolvency of Long-Term Capital Management, a hedge fund. Those four issues are the need for increased transparency, the need to eliminate excessive leverage, the need for better prudential controls, and the need for enhanced international cooperation, and harmonization of regulation.
The report recognizes the critical importance of heightened transparency in the markets by recommending greater disclosure and reporting by hedge funds. It calls for all hedge funds to report detailed financial information, including information about their exposure to market risks on at least a quarterly basis. For hedge funds operated by commodity pool operators or CPOs, the report recommends that such reporting such be accomplished through amendments to the CFTC's reporting rules. The Commission's staff is currently preparing recommendations for rule amendments to require such reporting by CPOs. For hedge funds that are not operated by CPOs, the report recommends that Congress should enact legislation that authorizes mechanisms for such disclosure. The hedge fund financial information would be provided not only to regulators, but also to the public at large. It would thus be available to hedge fund investors, creditors, and counter-parties to assess the credit worthiness of a hedge fund. It would also be available to regulators and market participants to help assess market integrity and financial stability in the financial markets.
In addition, the report recommends that all public companies should be required publicly to report their exposure to highly leveraged financial institutions. The report also emphasizes the need for enhanced risk management efforts by regulated entities, such as futures commission merchants or FCMs and the need for enhanced oversight of those efforts by regulators. It endorses the view that prudential supervisors and regulators should promote the development of more risk sensitive approaches to capital adequacy.
Page 13 PREV PAGE TOP OF DOC Segment 1 Of 4 In addition, the report recommends that regulators should have expanded risk assessment powers relating to unregulated affiliates of FCMs and securities broker-dealers. To effectuate this recommendation, the report recommends a change to the Commodity Exchange Act to grant the CFTC expanded reporting, record-keeping, and examination authority for unregulated affiliates of FCMs. This authority would provide the CFTC with needed information about the potential risks that an unregulated affiliate might pose to its related FCM and to the financial system.
I commend these recommendations to the subcommittee and urge that enabling legislation should be adopted.
Finally, the report recognizes the need for enhanced international cooperation among regulators to encourage the adoption and implementation of international standards governing hedge funds and credit exposure to them.
Although it's appropriate to await the recommendations of the President's Working Group Study on OTC Derivatives before endorsing additional specific changes to the Commodity Exchange Act, it is clear that developments in the OTC market have implications that may merit further changes to the statutory framework.
Thank you very much for the opportunity to appear, and I would be happy to answer any questions.
[The prepared statement of Ms. Born appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
STATEMENT OF BARBARA PEDERSEN HOLUM, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
Page 14 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. HOLUM. Thank you, Mr. Chairman. Good afternoon, ladies and gentleman, Mr. Chairman, and members of the subcommittee. Thank you for the opportunity to testify here today. The views I am expressing are my own and are not the views of the Commission. I wish to commend the subcommittee for recognizing that reauthorization of the CFTC raises important policy questions concerning both U.S. and global financial markets.
While the three main purposes of the Commodity Exchange Act: financial security, market integrity, and customer protection remain valid, evolutionary change in the marketplace demands new approaches in achieving these objectives.
I view this reauthorization process as an important and positive opportunity to eliminate a regulatory posture which simply does not fit current financial markets and institutions. We should not continue to try to make our dynamic and innovative markets conform to in some cases outmoded regulatory programs. Instead, we as regulators of the most creative and successful markets in the world should be looking ahead and working closely with other regulators and industry participants to craft regulatory oversight which works.
I would like to briefly review for you three recent examples of why we must move quickly away from the rigid, prescriptive micro-management approach to regulation.
The CFTC's unilateral effort to initiate expanded regulations of the over-the-counter derivatives market failed to achieve acceptance among those with either a business or regulatory interest. The concept release on OTC regulation, which included more than 70 questions about the best approach to regulate that market, succeeded only in increasing legal uncertainty. As a corrective measure, we must adopt an open and cooperative attitude toward working with our fellow regulators, the SEC, the Treasury, the Federal Reserve Board, and the Congress, as was not done with OTC derivatives.
Similarly, a burdensome approach in regulating agricultural trade options failed to expand risk management tools available to agricultural producers and consumers. Although the CFTC received overwhelming comment from agricultural interests cautioning against the implementation of detailed prescriptive rules, the CFTC nonetheless promulgated extensive and costly regulatory mandates. The result to date is that after more than a year, not one person has registered as an agricultural trade option merchant. We must listen when market participants advise us on the design of risk management programs, as was not done with the agricultural trade options program.
Page 15 PREV PAGE TOP OF DOC Segment 1 Of 4 Current debate surrounding the CFTC's proposed rules on access to foreign terminals again shows that a rigid approach to regulation is inapplicable in the modern business environment. As part of this initiative, there has been a moratorium on any action to permit the placement of foreign terminals in the U.S. since late 1997, which has imposed an unfair burden on competition and denied end-users in the U.S. the benefits of access to foreign markets. The CFTC should never again propose rules and regulations prior to adequate consultation with the industry and with all CFTC Commissioners.
As you may know, I am chairman of the CFTC's Global Markets Advisory Committee. The purpose of this committee is to advise the Commission on issues concerning the competitiveness of U.S. markets and U.S. firms engaged in global business. Recognizing the critical importance of addressing the competitive regulatory issues facing U.S. exchanges, we have formed a steering committee to identify and recommend solutions to the regulatory parity issues surrounding automated access to foreign exchanges. Our domestic exchanges have been and should remain at the forefront of this industry and should not be impeded by unnecessary and burdensome regulations. At the same time, we must ensure that our markets remain the safest and the soundest in the world.
We cannot stop the technological advances that are rapidly redefining the way the industry does business. Instead, we must recognize the extraordinary benefits of these vast new technologies. New technology benefits us as regulators by providing new tools that enhance our market and trade practice surveillance capabilities. Likewise, the exchanges must be permitted to maximize the benefits of new technology on their trading floors and in their surveillance departments. To do so, they must not be subject to the same set of requirements designed for a different era of trading.
As we chart a course to take us into the next millennium, we must not attempt to micro-manage our markets. Such an approach risks regulatory gridlock that stifles innovation, impedes productivity growth, and harms U.S. competitiveness.
Page 16 PREV PAGE TOP OF DOC Segment 1 Of 4 In conclusion, as we work together over the next several months on this reauthorization process, I hope our end product will reflect the following three elements: cooperation, flexibility, and democracy. We are a free society overseeing a free market, adopting rules and regulations in concert with, not in spite of, all other regulators and all other market participants.
Thank you. I would be pleased to answer any questions.
[The prepared statement of Ms. Holum appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
Now, Commissioner Spears.
STATEMENT OF DAVID D. SPEARS, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
Mr. SPEARS. Thank you, Mr. Chairman. Good afternoon. Mr. Chairman and members of the subcommittee, I appreciate the opportunity to testify here today as you continue to gather information in preparation of CFTC reauthorization. My remarks, which represent my own personal views and not the official position of the CFTC, will be rather general in nature. As you know, the Commission expects to be joined very shortly by two new members, including a new chairman. When that new membership is in place, I expect one of our top priorities will be to reach consensus on formal agency positions regarding a wide range of specific reauthorization issues. For now, I would like to share with you a few general thoughts on inherent challenges of this reauthorization process and some of the policy considerations that are critical to meeting these challenges.
In my view, the primary challenge for today's financial regulator is keeping pace with changes in the industry it regulates. This is especially true in the CFTC's regulatory arena, where recent years have seen globalization of the financial markets, remarkable new electronic trading technologies, a bewildering array of new products, and challenges to U.S. futures exchanges from both overseas and over-the-counter competitors.
Page 17 PREV PAGE TOP OF DOC Segment 1 Of 4 As we take up the challenge of amending the CEA, I believe one of this committee's most difficult task will be finding the appropriate balance between competing policy considerations. I believe the process of regulation should be a public/private partnership, a cooperative system that enables the U.S. futures industry to grow and prosper. I recognize the industry's legitimate concern over the competitive challenge they face from foreign markets and OTC competitors. I understand the need to reduce unnecessary regulatory burdens so they can meet that competition on a level regulatory playing field. But where will that level be? Achieving regulatory parity will entail difficult policy choices involving the structure of financial security, market integrity, and customer protection standards that have been the cornerstone of U.S. futures regulation for over 70 years.
I recognize that the sophisticated, professional traders who account for the vast majority of the financial futures volume do not need the same level of regulatory protections as smaller traders. However, we cannot forget that granting regulatory relief to those market professionals could lead to a two-tiered market structure. The second-tier, residual market, which would surely include a greater proportion of the agricultural contracts, could face diminished price discovery capability, and proportionately greater regulatory costs.
I realize that OTC markets need legal certainty; and I strongly support CFTC's cooperation as part of the President's Working Group on Financial Markets to help provide that certainty. However, as noted in the Working Group's Hedge Fund Report, efforts to provide legal certainty cannot ignore such factors as potential systemic risk from the activities of highly leveraged institutions.
I recognize that it makes no sense to saddle electronic trading systems with rules originally designed for open outcry trading pits. Over one half of the CEA's requirements for exchanges do not even apply to electronic systems. But switching to electronic trading will not turn everyone in the marketplace into a saint. Somebody will still need to take responsibility for protecting customers in the electronic marketplace from abusive trading practices and fraud.
Page 18 PREV PAGE TOP OF DOC Segment 1 Of 4 As Congress tackles these difficult policy choices, I would like to stress one additional point. The Commission, U.S. futures exchanges, and market participants all need a CEA that is flexible enough to allow for appropriate regulatory responses to changing circumstances. Let me give you an example of the benefits of flexible statutory authority. Last June, the Commission issued rules for an agricultural trade options pilot program. Those rules were drafted in the immediate aftermath of the hedge-to-arrive crisis. In my view, an understandable desire to avoid similar problems with agricultural trade options resulted in a program with a few too many bells and whistles. The result, exactly nobody signed up for the program. The good news, however, is that our staff is now hard at work drafting amendments to make the pilot program more user friendly. We can do this because of CFTC's broad statutory authority over options gives us the flexibility to adjust our regulations as needed. Also, when implementing these or any regulatory changes, the agency should apply a rigorous cost-benefit analysis. Bear in mind, however, that both the costs and the benefits of futures regulations are very hard to measure.
CFTC reauthorization has always been a difficult and controversial process. The stakes are too high to expect anything else. But reauthorization does not have to be a disagreeable, antagonistic process. I believe the best results can be achieved with an open mind and a cooperative attitude. In that spirit, I have held numerous meetings with representatives of the exchanges, the brokerage community, and farm organizations aimed at better understanding the competing interests and seeking consensus where possible. I plan to continue that process as the reauthorization debate continues. I commend this committee for getting an early start in the reauthorization process, and I look forward to similar cooperative efforts with this committee. I am confident that these efforts will result in a reauthorization bill that will enable the CFTC and the market it regulates to meet the challenges of the 21st century.
Thank you. I will be happy to answer any questions the committee might have.
Page 19 PREV PAGE TOP OF DOC Segment 1 Of 4 [The prepared statement of Mr. Spears appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Commissioner Spears.
STATEMENT OF JAMES E. NEWSOME, COMMISSIONER, COMMODITY FUTURES TRADING COMMISSION
Mr. NEWSOME. Thank you, Mr. Chairman, members of the subcommittee. I am pleased to be here, and I thank you for the opportunity to discuss reauthorization of the CFTC. I believe that this process provides a unique opportunity for Congress to make necessary changes to the act that will benefit the industry and market participants, as well as provide clear guidelines for appropriate regulation.
I would like to begin by stressing to over-arching principles: providing legal certainty and decreasing regulatory burdens should be the key elements in any review and amendment of the act. In order to do this, we need to listen to industry participants regarding the effects of regulation on the day-to-day matters of financial and agricultural risk management and price discovery. As responsible regulators, the Commission must be responsive to not only industry but also to the Congress as we work through reauthorization to develop a regulatory scheme that discourages fraud and manipulation but encourages innovation, technology, fair competition, and sound business practices.
Let me also stress another important point. It goes without saying that business will seek to operate in the most efficient fashion. Accordingly, if the opportunity presents itself to avoid regulatory costs by operating outside the borders of the United States, many business will make the logical decision to take advantage of that opportunity. Therefore, I believe it is critically important to engage in sensible cost-benefit analysis when making regulatory decisions. With the exodus of business beyond our borders goes the ability of the United States to continue to make policy determinations that affect the global economy. I firmly believe that we as lawmakers and enforcers must be acutely sensitive to this issue in order to maintain the primacy of our markets as worldwide leaders and innovators.
Page 20 PREV PAGE TOP OF DOC Segment 1 Of 4 I join with you in the desire to identify areas I believe have suffered from regulatory overreaching. I have already begun the process of taking steps to initiate changes that can be made under our current regulatory authority. I recently convened a meeting with representatives from the three largest futures exchanges in the United States to discuss concrete, practical initiatives that we can undertake promptly to address our regulatory concerns. I was extremely gratified with the outcome of that discussion and have accumulated a significant list of projects that I believe the CFTC can and should act upon in an expeditious manner.
Along those lines, let me say I believe that regulatory reform should be industry driven and that market discipline and adherence to best practice standards can achieve better enforcement of market integrity concerns than can any amount of overlaid regulation. Accordingly, I advocate stripping away unnecessary, costly regulation, while at the same time maintaining the ability to ensure forceful, swift prosecution and significant punishment for those outliers who commit core violations of the act. The industry needs regulation that fosters efficient and liquid markets, enhances the ability of market participants to innovate and compete effectively and does not create artificial and costly barriers to trade and competition. Ultimately, I believe the CFTC should concentrate on what Congress intended us to do when you created the Commission in 1974, that is, protect participants against fraud and manipulation and ensure safe, sound, and competitive markets.
It has become increasingly clear that we are witnessing a sea change in the way markets work. For example, who would have thought 10 years ago that we would be considering trading over the Internet? Who knows that technological advancements and future synopsis trading will be presented to us in 10 more years. It is critically important that the CFTC have the flexibility to be innovative regarding those within industry who are creative and visionary, and we must work with the Congress in determining how much regulatory agility the Commission needs to address the changing technological environment in order to encourage and not impede those who think outside the traditional box.
Page 21 PREV PAGE TOP OF DOC Segment 1 Of 4 At the time of the promulgation of the act and regulations, it obviously was not possible to contemplate such incredible changes in the way markets today conduct business. Accordingly, I think Congress needs to take a comprehensive look at the act with an eye toward making amendments to accommodate these changes relating to electronic trading. For example, the provisions relating to designation of completely electronic exchange should be reviewed. Also, the movement to electronic trading systems may have an effect upon the design of exchange Government systems. The current law envisions designation of traditional membership exchanges as opposed to proprietary exchanges. And I believe these issues also deserve congressional attention.
In May 1998, the Commission issued a concept release relating to over-the-counter derivatives which created significant legal uncertainty in a dynamic and vital market and ultimately resulted in a moratorium until Congress has the opportunity to address the issue. That opportunity is now before you. I recognize that there are several different avenues that have been suggested to you in this area. The various sectors of the industry must make clear what their concerns and desires are in order for you to best make your determination in this area.
There has, as in the past, been discussion of reducing the regulatory authority of the CFTC and/or merging the CFTC and the SEC. I believe the agricultural emphasis should be maintained in a clearly defined way, given the role commodity markets play as significant risk management and price discovery tools for American agriculture. In whatever manner this issue is ultimately addressed, the CFTC should have the statutory flexibility to allow markets to continue to be useful mechanisms for agri-business concerns.
Finally, I believe that the Commodity Futures Trading Commission has an extremely talented and dedicated group of people committed to public service. And, Mr. Chairman, I am proud to be associated with them. However, the fact of the matter is that times have changed, and we must change with them. I am confident that we have professional responsible staff to carry out the mandates issued by this Congress. Let me reiterate my belief that providing legal certainty and decreased overly burdensome regulation should be paramount concerns as you proceed in this task, and I am committed to working with you, your staffs, other regulators and industry participants as we take advantage of this opportunity to modernize the CEA. I recognize that this will not be an easy or quick undertaking and that it will require the compromise on the part of all interested parties. However, the costs of not reaching consensus in this area is high. And I encourage the industry to continue their efforts to make their viewpoints known to Congress and to regulators.
Page 22 PREV PAGE TOP OF DOC Segment 1 Of 4 Thank you, Mr. Chairman.
[The prepared statement of Mr. Newsome appears at the conclusion of the hearing.]
Mr. EWING. Thank you to all of you and thank you again for being here. I think the tenor of your testimony is all very positive and you recognize I believe the need for change and for modernization of the act.
Chairperson Born, you outlined in your testimony a number of regulatory reform initiatives undertaken by the CFTC in the last 2 1/2 years. How would you judge those as far as effectiveness?
Ms. BORN. I think they've been quite effective. The source of many of the ideas for regulatory reform that the Commission has adopted in the last 2 1/2 years came from the industry. We have had an active outreach to the industry, to the exchanges, to the commodity professional community, as well as to market participants. And the vast majority of these reforms were suggested by the industry and then implemented by the Commission. I think they have been designed to expedite our consideration of rules and new contracts so that most new contracts now are considered in 10 days or 45 days and approved. Most rules, virtually all rules, I think over 80 percent, are approved within 10 days. They also have recognized the development of technology by permitting a lot of communication between the industry and the Commission, between commodity professionals and their customers by electronic means. Also, in addition to the regulatory reforms that were listed there, the Commission has for the first time approved an all electronic exchange and had to go through the process of deciding which of the regulations and provisions of the act should be applicable to that exchange. We have also approved a concurrent electronic and open outcry trading on CME and CBOT.
Mr. EWING. Would you believe that the industry would give the Commission high marks for these reforms or have there been many that they may have suggested that weren't adopted?
Page 23 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. BORN. There are some that are still in the works that have been suggested. For example, one on notional funds and the way performance by CPOs and CTAs are measured is still in the rulemaking process. There are several others that have also been more recently recommended are our staff is working on. So this is not a completed work. This is a work in progress, and I sincerely hope that the industry will continue to be as helpful to the Commission in making suggestions for regulatory reform as it has been during my tenure.
Mr. EWING. Thank you. Commission Holum, you are Chair of the Global Markets Advisory Committee. What elements make it advantageous for participants to conduct business abroad rather than here in the United States, what has your committee found?
Ms. HOLUM. Well, as the markets become global in nature, there are links between U.S. exchanges with foreign exchanges and technology is opening up trading across time zones and across boundaries and it's beneficial to U.S. business to have these added opportunities. And the reason the Global Business Advisory Committee was formed was for U.S. business to look specifically at potential barriers to cross-border trading. And this is very much in the interest of U.S. businesses. We are working on several issues, working with international and national regulators and exchanges in an effort to harmonize regulations and the way to facilitate increased business cross-borders. And I'm very pleased, we have on this committee about 30 of the major financial service people in the futures industry in this country who are working very hard on promoting harmonization of rules and regulations.
Mr. EWING. Do you feel that some of the competition overseas gets to play by an easier rule book than American industry?
Ms. HOLUM. Well, there certainly is a concern about that and, as a matter of fact, just last week, we put together a committee of exchange representatives in the futures industry to very specifically identify what some of those differences might be in an effort to make sure that there are no advantages given to foreign exchanges. And we have told our U.S. exchanges and futures industry that we will work very closely with them in an effort to make sure that there is not a regulatory imbalance.
Page 24 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. Would you say though at this time that there is some imbalance between our competition overseas and what our industry at home faces?
Ms. HOLUM. Sir, I really couldn't make a statement like that because there are a lot of concerns and worries about that, but what we need to do is look specifically at the issues and that's what this committee had undertaken to do so that we can all answer that question.
Mr. EWING. But don't you have to look at it as a whole?
Ms. HOLUM. Definitely, we do.
Mr. EWING. I mean don't you have to come of with some idea whether there is indeed an imbalance or not in the total complex of the regulatory scheme?
Ms. HOLUM. Yes, and there are international organizations like IASCO who have been working on this and taking surveys and identifying where there are regulatory differences. So this committee that I'm talking about is really hopefully within a very short period of time, their goal is by the middle of June to identify specific regulatory irregularities that we can then deal with. So in answering your question, yes, we will have specifics. And where it's necessary to resolve those differences, by rulemaking in some instances, the CFTC may be able to resolve those issues by rulemaking procedures. In others, it may require congressional action, and we will be prepared to bring those results to you.
Mr. EWING. Well, I think one of the concerns I have in my observations and my involvement is that we do it in minutiae, and we never get a whole picture, and yet the industry has to face the whole picture and that's where their competition is out there. And I certainly would encourage committees at the Commission to be looking at the whole picture and what the competition is.
Commissioner Spears, you chair the Agricultural Advisory. One of the reforms has been the agricultural options. Why hasn't that worked?
Page 25 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. SPEARS. That's a very good question and the answer is not quite as simple as the question, but I think it has not worked for a number of reasons, basically three reason. One is simple economics. Current commodity prices have not been in place where a lot of farmers wanted to lock in the future prices. So certainly economics have been a part of that. Second, I think informational reasons are part of the reason why it has not worked so far. There has been a lack of education, lack of information about the tools out there. As has been commented by both Commissioner Holum and myself, the program has been in place for about 11 months and no one has used the program yet. And partly, the third reason, probably a few too many bells and whistles on the pilot program rules themselves.
And as I testified here, our staff is hard underway working for a number of reforms and changes in those rules. Also, I would be happy to provide this committee copies of the testimony the Commission gave in the Senate 2 weeks ago on May 5 on agricultural trade options. I have brought copies of both the Commission's written testimony that I presented to the committee, as well as my oral testimony. So if the committee would be willing, I would like to submit that for the record as well.
Mr. EWING. We would appreciate having that. It would be very good.
Mr. SPEARS. Also, I like to just mention that part of that process, nine of the major farm organizations who make part of the membership of the Agriculture Advisory Committee, there are 25 organizations that comprise the Agriculture Advisory Committee, submitted a letter to me on April 23 with some recommendations as to revisions in that program, and I would also be happy to provide a copy of that to the committee as well.
Mr. EWING. Do you anticipate that there will be some revisions to try to make the program more
Mr. SPEARS. Yes, I certainly do. There are a number of issues that we have reached consensus on so far. We debated those issues at the last Advisory Committee meeting on April 21 of this year, as well as last August. I anticipate that our staff will be bringing recommendations to the Commission within the next few months. And we can issue or submit at that point in time some revised rules to the program for public comment. Depending on the comments, then hopefully we will have those rules in place later this summer or this fall.
Page 26 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. Mr. Newsome, I think you are the most recent Commissioner?
Mr. NEWSOME. Yes, sir.
Mr. EWING. So you have the most experience, right? You talked about the current power to reduce over-regulation or excessive regulation or regulation, make changes, whether it is excessive or necessary, whatever. Do you believe that the Commission from your rather new viewpoint could do a lot more to really reorganize itself under the current statute?
Mr. NEWSOME. Let me begin, Mr. Chairman, by saying first of all, I appreciate my first opportunity to appear in front of this committee. I came from a production agriculture background and was unaware of particularly of the complexity of many of the financial markets in which we are exposed. So I think in partial response to your comment earlier, I had the opportunity to come in without bias and take an overall look at the whole situation. I think that has been very helpful to me. I do think we have opportunities within our current regulatory authority to decrease the regulatory burden on our exchange community.
I had the opportunity to meet with the three largest exchanges just over a week ago, and I was very gratified at the outcome of that meeting as I asked them to bring to the table very practical regulatory concerns that I thought the Commission could address. And we had a very productive meeting. I don't think that all of the regulatory concerns can be addressed under our current statute, but I think many of them can, those that need to be addressed by Congress are in the minority, however.
Mr. EWING. Thank you.
Mr. ETHERIDGE. Thank you, Mr. Chairman. Let me thank you also for convening this hearing today because it is so important as it relates to the reauthorization of the Commodity Exchange Act that means so much to agriculture. And, Mr. Newsome, since you have just finished, I am going to go back to you, if I may, because in your testimony, you raised some issues that triggered some concern for me as relates to the regulation of over-the-counter derivatives that you raised that issue in your testimony. Would you please elaborate on the issue of legal certainty as it relates to the systematic risks in competitive issues as they relate to the security-based swaps that you talk about?
Page 27 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. NEWSOME. Yes, sir, I will be glad to. The over-the-counter derivative issue is very complex issue. I think there are legal concerns as well as regulatory concerns. And not long after I came on board the Commission last fall, it became an issue that confronted us, and as far as the industry was concern, the concept release that the Commission put out did raise legal uncertainty. I was part of a majority of the Commission who wrote a letter to this committee and to the Senate Agriculture Committee suggesting that the Commission would not take action on this issue until such time as Congress had the opportunity to address it because I thought there were some real fundamental questions that needed to be addressed by Congress prior to the CFTC trying to address it. Congress took action and actually placed a moratorium, in effect not allowing the Commission to take action until Congress had the opportunity to look at it.
I think as far as equity-based swaps, they are linked to the Shad-Johnson Accord, so I think those two issues are fitted together, and I think they are going to have to be addressed as such.
Mr. ETHERIDGE. OK, let me follow it up with one other question, if I may, since we are on this topic. Why, in your opinion, have OTC derivatives grown more rapidly than futures in recent years?
Mr. NEWSOME. I think there are probably several reasons. One, there is less regulation in over-the-counter markets. Two, for the most part, these are private negotiations between commercial parties and then they are able to set up that swap based upon their needs or their concerns, so it has a lot of flexibility to it. And I think that and less regulation have been the two primary factors.
Mr. ETHERIDGE. So your point is it is less regulation that is required of products that really are traded off the exchange?
Mr. NEWSOME. Well, I think particularly in that instance when you have got a transaction
Page 28 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. ETHERIDGE. Compared to the exchange?
Mr. NEWSOME [continuing]. That is between two parties and not offered to the public, I think that's the case.
Mr. ETHERIDGE. OK. Madam Chairman, let me ask you a final question as relates to this whole issue. Do you believe agricultural products require different regulations than other products?
Ms. BORN. I wouldn't separate agricultural products from other products. I think agricultural products and other commodities are more susceptible to manipulation than some financial instruments and therefore the scrutiny to prevent manipulation is particularly important when you are dealing with physical commodities. We have had experience with manipulation of financial instruments. Soon before I came on board in 1996, the Commission found a manipulation of the U.S. Treasury notes market on CBOT and held an entity liable for that. So the financial markets are not immune. But certainly where you have physical delivery, where you have a commodity where the commercial interests are relying on exchange pricing for commercial pricing, you have very, very important requirements for manipulation prevention, prohibition, and punishment.
Mr. ETHERIDGE. Thank you. And thank you, Mr. Chairman.
Mr. EWING. Thank you.
Mr. BARRETT. Thank you, Mr. Chairman. I, too, want to thank you for holding this hearing on a very, very complex matter. And it is also niceI compliment you, Mr. Chairman, for four Commissioners testifying before this subcommittee. I don't know what you did to get four Commissioners here at one time, but you are to be thanked.
Mr. Newsome, I was interested in your comments about reducing regulatory burdens, the paperwork, the bureaucracy, and so forth. And then I thought to myself, Ms. Born I believe you made reference to the President's Working Group on Financial Markets regarding hedge funds, particularly the Long-Term Capital Management.
Page 29 PREV PAGE TOP OF DOC Segment 1 Of 4 Well, talk to me about it because it occurs to me that the recommendation that you make in here, in scanning the larger report and not this report, authorizes the regulators to require broker-dealers, FCMs, other unregulated affiliates to issue credit risk reports by it appears to me a counter-party, a third-party, a disinterested party. Don't you have that authority now?
Ms. BORN. The authority that is being recommended by the President's Working Group and the administration is to broaden the Commission's authority and the SEC's authority over the unregulated affiliates of FCMs, as far as the CFTC is concerned, and securities broker-dealers for the SEC because of the risks that some of those unregulated affiliates pose for the financial stability of the regulated entity, the FCM or the broker-dealer, and the marketplace as a whole. The basis for this recommendation comes from the fact that many of the larger participants in the over-the-counter derivatives market are not regulated FCMs or regulated securities broker-dealers but are unregulated affiliates of those entities. They can have very significant exposures to credit risks, to liquidity risks, to other problems that the President's Working Group found in our study on hedge funds. And, therefore, the recommendation is that our powers be broadened in terms of getting records and reports from those unregulated affiliates, having the ability to examine their books and records, and also their stress testing and other risk management practices.
Mr. BARRETT. If this were in fact to be done, would this require statutory change?
Ms. BORN. Yes, I think we need some additional statutory authority. Also, the SEC needs some additional statutory authority. Certainly, our staff is looking at the question of exactly what additional authority we might need. I suspect the President's Working Group as a whole will also address this together, but we would be prepared to make recommendations once our staff has done this analysis and conferred with the staffs of the other members of the President's Working Group to make a recommendation to this committee and to the Senate Agriculture Committee at the same time.
Page 30 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. BARRETT. Good. Inasmuch as we are talking about reauthorization, in your opinion, again, Ms. Born, do you think the authorization should be permanent or should we continue on an interim basis? And if so, why?
Ms. BORN. Well, I personally think that the time has come to consider permanent reauthorization. The Commission will be 25 years old next year. When the statute was adopted in 1974 that created the Commission, it was understandable that Congress thought that this was an experimental matter and that a sunset provision would be appropriate. I think at this point, it is clear that the futures and option markets of the country do need some oversight. I think that congressional oversight of the Commission is critically important, and I believe I have appeared on a large number of occasions in the last 3 years before this subcommittee and have welcomed those appearances.
On the other hand, I do not think that for you to exercise your oversight authority, you really need to have us all go through reauthorization on a periodic basis. It takes up an enormous amount of the resources of the Commission, which is a small agency, as agencies go, with a small budget. It also requires an enormous expenditure of time and resources by the industry we regulate. I think those resources could better go into business and regulatory innovation and that whenever you all felt that the CEA, the Commodity Exchange Act, needed revision, you would certainly be able to step in and do so.
Mr. BARRETT. Well, there is something to be said for a helpful overview of our futures markets.
Ms. BORN. Absolutely.
Mr. BARRETT. But you are comfortable with the permanent authorization, you think that there is enough oversight within the industry?
Ms. BORN. I am sure that Congress will continue to scrutinize the agency and its regulation of the industry appropriately. And I wouldn't recommend going to a permanent reauthorization if I believed otherwise.
Page 31 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. BARRETT. Thank you very much. Thank you, Mr. Chairman.
Mr. EWING. Mr. Goode.
Mr. GOODE. Thank you, Mr. Chairman. Could you tell me how the Commission is funded?
Ms. BORN. We are funded from general appropriations from general revenues. Our current budget is $61.4 million.
Mr. GOODE. Is your total source of fund then just general fund money?
Ms. BORN. Yes, and any fees or penalties we assess go straight to the U.S. Treasury. They don't come back to us. In fiscal year 1998, we assessed $132 million in civil monetary penalties, and I think got about $5 million in fees and other assessments. Those amounts went to the Treasury. We didn't collect the entire $132 million in civil monetary penalties. I think we collected between $125 and $126 million worth of that. And, as I said, our budget is $61.4 million.
Mr. GOODE. I noticed in your testimony on page 8 that you said that the Bank for International Settlements estimated that it was $70 trillion in notional value worldwide. What about in the United States, if you could break it down like that, what would it be?
Ms. BORN. It is very difficult to do. We can certainly try to get that figure for you.
Mr. GOODE. I just want kind of a ballpark?
Ms. BORN. This is an amount of over-the-counter derivatives transactions and that is a truly international global market. We have a number of our largest commercial banks and largest investment banks are the major over-the-counter derivatives dealers and therefore are participants in a large percentage of those transactions. But there are also international banks in Europe and elsewhere that are dealers as well. I can try and see if our staff can get the best estimate, but it is hard to measure because do you consider it a U.S. transaction when both parties or only one of the two parties is a U.S. entity, for example?
Page 32 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. GOODE. Assuming your definition, you just said at least what?
Ms. BORN. I would say more than half.
Mr. GOODE. To any transaction to which a U.S. citizen was one of the parties, corporate or personal, would it be half of that figure?
Ms. BORN. I would say it would be more than half.
Mr. GOODE. More than half, OK. That's all, Mr. Chairman. Thank you.
Mr. EWING. Mr. Smith.
Mr. SMITH. Thank you, Mr. Chairman. Help me understand a little bit about the pressure and the resistance to pressure, I mean with your oversight of groups that are in it for making a profit, some of your decisions on regulatory decisions have a substantial impact on the potential probability, is there significant pressure on Commissioners to make decisions that would be advantageous to one of the future trading groups that you oversee? Start with you, Madam Chairman?
Ms. BORN. We certainly get a goodly amount of input from interested parties on virtually every regulatory decision that we make. We have a tradition of open doors so that while we are in the process of deliberating on a regulatory matter, we not only get written public comment, but we as Commissioners permit visits by interested groups. We each write a memo to the public comment file memorializing those contacts. But I think I and the other Commissioners feel that it is very important for us to be open to all interests. Of course, on our adjudicatory and enforcement matters, that is another issue. We do not welcome ex parte contacts, and I don't think there are a significant number of ex parte contacts.
Mr. SMITH. Any other Commissioner would like to comment on that, all the pressure you get?
Page 33 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. HOLUM. I wouldn't classify it as pressure. I sort of look at it as an extensive education process.
Mr. SMITH. Yes, that's the way we look at it in Congress also. [Laughter.]
Ms. HOLUM. I look at it the same way. We really get a lot of information on how they do business and the economic pressures that they are under and the impact of many things that we do, it is important that we know how that impacts the way they do business.
Mr. SMITH. And, Commissioner Holum, I understood you to say because of the global markets that we have today, if other regulators in other countries are less restrictive, that could increase the decision of some of our traders to deal with those other markets then we should reduce our regulations as much as they are reducing their regulations? That is sort of what I sort of heard you say.
Ms. HOLUM. That is a very interesting point. If we want to bring about regulatory parity where there is a disparity, we don't have any authority over a foreign exchange, but in many instances, I think we can level the regulatory playing field by maybe relaxing some of the rules and regulations that are imposed on the domestic exchanges. And even though I can't answer that specifically, I am hopeful that within a very short period of time, we will be able to be very specific about where the irregularities are and have a proposal to correct those.
Mr. SMITH. Just on the surface, it would seem that there should be a discussion with other regulators in other countries of what is the best possible way to do this and then get some consistency in the way different countries regulate rather than having, if you will, a bidding contest of who has the least regulations, everybody has got to succumb to a lesser regulation even though it wouldn't cause problems sometimes?
Ms. HOLUM. You are absolutely right. The best way to accomplish this is to harmonize rules and regulations throughout all the markets. As markets become increasingly globally linked, it is to everyone's advantage that that happen. And, in fact, there are meetings going on and organizations who are trying very hard to make that happen.
Page 34 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. SMITH. Commissioner Newsome, I understood you to say in your discussions on regulatory reform with some of the exchanges, you had developed a list of recommendations. Have you given those to this committee?
Mr. NEWSOME. No, those have just been developed. And they were recommendations from the exchanges that I met with on issues that they felt could help decrease their regulatory burden and level the playing field. So I would be more than happy to share those with you.
Mr. SMITH. Good, if you will provide them to the committee, at least we could review and start massaging them a little bit. Is there a disadvantageous operating with four Commissioners versus five?
Ms. BORN. Well, in my view it is always most useful to have as many good, diligent Commissioners as possible. We have been at full strength throughout my term until the first of March when John Tull retired. There is a person who has been nominated for that seat and who has had confirmation hearings, but has not yet been confirmed.
Mr. SMITH. But that will bring you back up to four. My understanding is there hasn't been a fifth nominee yet?
Ms. BORN. Well, that is the fifth nominee. I am then retiring in 2 weeks.
Mr. SMITH. Oh, yes, I'm sorry, right.
Ms. BORN. And I very much hope that my successor will be nominated and confirmed expeditiously.
Mr. SMITH. Has the Commission, maybe I will direct this to you, Commissioner Spears, since I haven't asked you a question.
Mr. SPEARS. Fine.
Mr. SMITH. Has the Commission sat down and tried to go through all of this list of derivatives? What is your process of saying these type of derivatives we think is reasonable for us to have some oversight and including what participants you might consider appropriate for oversight by your Commission, how do you develop your decisions on what derivatives should have that kind of regulatory oversight, as well as the participants?
Page 35 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. SPEARS. Well, I believe that process is kind of an ongoing process, a work in progress. We try to take an overall philosophy and address that question, but also we have to look at them on a case-by-case basis a lot of times. As you know, the derivatives themselves, as commented before, are usually privately negotiated deals between two parties and we may get a request and review that particular contract. A lot of the over-the-counter business is done outside the Commission's purview, and so we try to respond by looking at the overall picture. And then when asked to respond to individual contracts or derivative deals, we respond at that point in time as well.
Mr. SMITH. Do any of the four of you recommend that by law, that we limit your regulatory oversight or to what extent is there an advantage to giving the CFTC the flexibility of deciding how much and when you impose regulatory oversight?
Mr. SPEARS. As I stated in my testimony, I believe the maximum flexibility is appropriate, where we could have flexibility to change rules. For example, I gave the example of agricultural trade options: we developed a pilot program, it didn't work. But given our broad authority, we can revamp that program and put out a new program that hopefully will work for agricultural producers. So I think the maximum flexibility would be desirable.
Mr. SMITH. And your comment, Madam Chairman?
Ms. BORN. I agree with that, and let me just add that I think since 1992, when Congress gave us the power to exempt futures contracts from some or all of the provisions of the act, the Commission has had the flexibility that it needs. We had prior to that the ability to exempt options from some or all of the provisions of the act. But with that exemptive power, which allows us to make an assessment of particular transactions in particular markets, to decide which of the statutory provisions a particular market should be exempted from, and under what terms and conditions it should be exempted, has given us the flexibility we need as a Commission to approach most issues at least to the extent that we have had them presented to us today.
Page 36 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. SMITH. Well, anyway, thank you all for your work. Can Mr. Newsome make a quick response?
Mr. NEWSOME. I just wanted to echo Commissioner Spear's need for the flexibility. I think, as I commented, I think if you look back 10 years ago, who would have thought that we would have electronic trading and that we would be trading over the Internet? I think the more flexibility the Commission has to be innovative from a regulatory standpoint to those who are very creative and visionary from industry so that we can encourage, not impede technological gains. I think the former chairman of the CFTC, Phil Johnson, made a comment at the Joint Senate House Roundtable a couple of months ago that if you look at the current Commodity Exchange Act, some 50 percent was no longer useful or outdated in terms of where the market is today. So I think that flexibility certainly is very critical to our need to address industry concerns.
Mr. SMITH. Thank you all for your service. Thank you, Mr. Chairman.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Mr. Chairman, thank you. I have been looking forward to this hearing, and I am very frustrated I had to miss the first hour of it, particularly most of this panel. The question I would have for you is kind of an off-the-wall one. It involves jurisdiction of this committee. While we look at all of this on the occasion of the reauthorization, I for one think maybe we should do some contemplation in terms of whether or not congressional oversight ought to be reviewed as well. Clearly, we have come a long, long way since the futures activities was strictly agriculture. And now that is not even most of what you do. I am wondering if you have thought as to whether it would be helpful or more appropriate or whatever relative to having other congressional committees, such as Commerce involved? It is unusual for a member of any committee to ever suggest that maybe their jurisdiction isn't perfectly aligned with the subject matter, but I think we ought to look at everything while we are at this. Now that really is an in-house congressional issue, and if you don't care to comment on it, that is fine. We will have occasion to talk about that as we go forward. But if you would have any thoughts, I would be interested in them?
Page 37 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. BORN. Let me say from my personal point of view, I have felt that the Commission has benefited greatly from being under the oversight of the House and Senate Agriculture Committees. On the other hand, it is quite true that our markets at this point are only about 14 percent agricultural. They are more than 70 percent financial instruments. I have found myself testifying as often in front of the House Banking Committee as I have before this committee. And the Senate Banking Committee has also taken up relevant issues. The House Commerce Committee has taken up relevant issues. There is a convergence of markets that is ongoing, a convergence of financial services providers is underway as well and instruments. And with that, I think there will be more overlapping interests and jurisdiction among the various House committees.
Mr. POMEROY. Any of the other Commissioners?
Ms. HOLUM. Well, I didn't think I would be ever asked to publicly advise Congress on how to do their business, but
Mr. POMEROY. And you needn't, if you don't care to volunteer.
Ms. HOLUM. No, I also agree that as the markets are changing so rapidly, and we can no longer talk about just commodities and just banking and just insurance, excuse me. The whole financial services industry is such that I think committees will just naturally wherever there is an issue, which ever committee is interested will and they do ask the Commission to respond. So I just say flexibility seems to have worked so far, and we certainly appreciate the broad knowledge that both of our authorizing committees have always carried into all of our deliberations.
Mr. POMEROY. Well, we would always want jurisdiction over the agriculture component of those markets, always. But I am not sure broad knowledge is a fair characterization of this committee's prowess on these matters. But I guess I hear both of you telling me the jurisdiction is already shared. There are already other hearings. To the extent that these financial instruments involve other jurisdictional areas, these committees are already operating. That is basically it?
Page 38 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. BORN. That certainly has been my observation.
Mr. POMEROY. But CFTC reauthorization will be exclusive Agriculture Committee jurisdiction?
Ms. BORN. I think there may be interest expressed by other committees in some of the issues that are quite appropriately reauthorization issues. I think the jurisdiction, primary jurisdiction is certainly in this committee. But I would not be surprised if the House Banking Committee or the House Commerce Committee or both expressed interest in some aspects of the issues.
Mr. POMEROY. Thank you.
Mr. EWING. The gentleman's time has expired. Mr. Thune.
Mr. THUNE. Thank you, Mr. Chairman. Let me just, this may be sort of a rudimentary question but one of the things I think in my part of the world, there obviously is a lot of suspicion to some degree about some of the tools that are available in the way that the financial markets work. I mean a lot of folks in my part of the world think they put their crop in the ground, they grow it, they sell it, they should make a profit. And that isn't always as simple as it is. And there is a lot of suspicion about the way the Board of Trade and the Merc, and so forth, work and what impact that might have on price. And I guess I would just like to know how does the current regulatory system protect against price manipulation, what sort of safeguards?
Ms. BORN. If I could start with the answer and obviously defer to the other Commissioners as well, our regulatory scheme is designed with a very significant thrust to detecting and preventing manipulation before it goes very far down the line. We rely very heavily on market surveillance of commodity markets, the agricultural markets, the metal markets, the energy markets particularly, but also the financial markets. We have staff who goes on to the floors of the markets on a daily basis. We also get daily reports from FCMsfutures commission merchantsabout all large trader positions in the futures market and the options market with the identity of the trader. And we have a team of economists who look at those daily reports to assess whether the people in the marketplace are there for legitimate commercial purposes. We have speculative position limits that go into effect in agricultural markets and other physical commodity markets at various stages of trading to try to make sure that there is not too large a speculative position being built up for manipulative purposes. The Commission has a weekly meeting on Friday mornings with our economists to get reports on signs of problems that they have detected in any of our markets and that is an opportunity for the Commission to advise the staff and also to take action if need be.
Page 39 PREV PAGE TOP OF DOC Segment 1 Of 4 Our staff is in very close contact with the staffs of the major exchanges on issues relating to concentrations of positions for seeming price distortions that aren't explained by normal supply and demand issues. On occasion, I phone up big traders. Certainly our staff phones up big traders to inquire about why they have the positions they have. I can call the head of an exchange or the president of a member of an agri-business corporation and raise these issues. We try to prevent manipulation before it happens.
Obviously, you can't do a perfect job, but we have a lot of very useful data, so that when your constituents have specific problems, we would encourage you to be in touch with us because we can make examinations and are continuously making examinations. We frequently report to Congress when there have been problems, as there was in heating oil a couple of years ago, and can report whether or not this was a manipulation or not and what the kinds of concentrations by various kinds of participants in the market have been.
Mr. THUNE. In your judgment, the sort of the regulatory framework that has been in existence for a long time, the self-governance concept works. Are there down sides? I mean are there things that you perceive that perhaps are conducive to or permissive to manipulation?
Ms. BORN. I think we have quite a good system for trying to detect and deter manipulation. I think a strong enforcement arm is also important so that the Commission's decision last year imposing the largest civil monetary penalty ever assessed by the United States Government on Sumitomo Corporation for manipulating our copper markets along with copper markets around the world was very significant. We fined them $125 million and also got an extra $25 million that went to private litigants as part of our settlement with them. And I think that kind of enforcement effort is extremely important and a big addition to our prevention and detection activities.
Mr. THUNE. I can see my time has expired, Mr. Chairman.
Page 40 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. Thank you. Mr. Moran.
Mr. MORAN. What I am concerned about, what I see today in your testimony is apparently a divergence of opinion among the members of the Commission. Two of you in your written remarks indicate that your speaking personally on behalf of yourselves and not as a Commission. I assume that's true of the four Commissioners present. Could you explain to me, to the committee what the basic disagreements are, what issues are there and do those disagreements impact how we should be viewing certain policy issues as we look at reauthorizing the act?
Ms. BORN. Certainly, I will go first, but obviously the other Commissioners can chime in. I gave my own personal views, and I think the other Commissioners gave their own personal views because we were invited to all appear and testify individually. I also think that, from my personal view, it is a little premature for the Commission as a whole to be taking positions on reauthorization. Number one, I hope we are about to have a new confirmed Chair who will lead the Commission through reauthorization. Number two, we are also missing another Commissioner who has been nominated and is going through the confirmation process. No. 3, we have not yet fully seen the views of our constituents.
We received within the last week or so the responses to Senator Lugar's 48 questions on reauthorization from some members of the regulated entities that we oversee, which I think is a start. And certainly these hearings are a start in hearing the views of the various constituent entities. But at least from my part, I thought it was premature until we heard the views of the diverse range of the public who were interested in this for the Commission to come to Commission views.
Finally, we have been working with the President's Working Group on the hedge fund study that then came out 3 weeks ago and on an over-the-counter derivatives market study that has not yet been completed and hopefully will come out some time this summer. A great many of the issues that are going to be posed by reauthorization will I think be covered by those two studies, certainly some of them are covered by the hedge fund study. And as a member of the President's Working Group, I did not want to pre-judge the results of that study and ultimate report.
Page 41 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. MORAN. Having said all that, let me ask in a more artful way, are there disagreements among the members of the Commission that we ought to be aware of that have policy implications for us as we try to reauthorize the act?
Ms. HOLUM. I would just like to add to that I think it is customary for the Commission during the reauthorization process to come forward to the Congress with a Commission position and that hasn't been done yet because it is very early in the process. But I certainly expect that that will be done so that there will be a Commission position and where there isn't, the Congress would be notified. But that is historically what the Commission has done.
Mr. MORAN. Historically in my 3 years here, that was the case in the past. So my history is brief, but before the chairperson testified with the Commissioners seated behind her.
Ms. BORN. Well, certainly had I not been a lame duckI mean my term expired more than a month agoI would have felt that it was appropriate to try and at least get some preliminary views. I do not think it is appropriate with a new Chair coming on who will lead the Commission through reauthorization. I think he or she deserves to participate in that process.
Mr. MORAN. I have tried twice to get to the substance as compared to the procedure. Anybody want to take on the substance of any disagreements among the Commissioners?
Mr. SPEARS. We may have differences of opinions on individual points on a particular issue, but I think all in all, most of the time we can come together as a Commission with a majority view, the majority of the Commission can come together and bring to this committee the majority view of the Commission at the appropriate time. So it is hard to sit here and pinpoint individual differences, sir, but I am confident that this Commission can work together and bring back to you a majority view at the appropriate time.
Page 42 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. POMEROY. Will the gentleman yield?
Mr. MORAN. I will be happy to yield, although the light is amber.
Mr. POMEROY. I was just going to observe that around here, you don't want to put a lot of stock in the majority view. It is quite often flawed. [Laughter.]
Mr. MORAN. Reclaiming my time and it is expired, Mr. Chairman. [Laughter.]
Mr. EWING. Do you need extra time?
Mr. MORAN. I don't think I am going to get the answer, and I do appreciate Mr. Spears, Commissioner Spears calling me ''sir.'' That's the first time that I have ever been called that. [Laughter.]
Mr. EWING. Is he from Kansas?
Mr. MORAN. He is a Kansan.
Mr. SPEARS. And a constituent.
Mr. EWING. Mr. Hayes.
Mr. HAYES. Thank you, Mr. Chairman. With respect to Treasury amendment products, there seems to be some legal uncertainty on certain issues. Is there any progress being made in resolving whose turf is whose on those issues?
Ms. BORN. Well, this may be an issue that is addressed in the President's Working Group Study on Over-the-Counter Derivatives. Certainly, it is being looked at very carefully, and I hope there will be a consensus on those issues the way there was a complete consensus or a virtually complete consensus on the hedge fund issues.
My biggest concern in this area is one that I mentioned in my testimony, which is that bucket shops are pinpointing retail customers, often retirees or immigrant communities for fraudulent schemes in foreign currency futures and options. This has reached epidemic proportions. The Commission has brought a great many actions in this field. The North American Association of Securities Administrators are very concerned because they have a rash of cases like this, and there is some uncertainty and difference among the U.S. Courts of Appeals, the circuits, as to the degree of the Commission's authority in that area.
Page 43 PREV PAGE TOP OF DOC Segment 1 Of 4 I think it is very important for there to be clarification there and some clear designation of authority to go against these fraudulent schemes, hundreds of millions of dollars have been lost by customers in the cases brought by the Commission alone and many cases aren't being brought. For example, in the Ninth Circuit, we can't bring cases because the Ninth Circuit has ruled we have no jurisdiction.
Mr. HAYES. Would you or any of the other members have additional recommendations for the President's Group on areas that could be clarified as it relates to the Treasury amendment?
Ms. BORN. There are a number of areas that are being worked on by the President's Working Group. Actively, we have been working on this since last fall. Our staffs meet every 2 weeks on these things. Our staffs are actively drafting parts of the report, and I hope that there will be a comprehensive report on all over-the-counter derivatives issues that will be available for the Congress some time this summer.
Mr. HAYES. A couple of years ago, some efforts made to work out disagreements between Treasury and CFTC. Where are we on this issue and are we getting closer to some sort of compromise?
Ms. BORN. Well, as far as I am concerned, I think the four agencies are working very closely together in this OTC derivatives study, just like we did in the hedge fund study. And there is a great deal of cooperation. It is a little premature to say whether there will be a consensus there on recommendations. I think it will clearly be after my term and the new Chair of the Commission will be serving on the President's Working Group at the time that that report comes out. But from my observations, there has been very good progress made in discussions.
Mr. HAYES. Thank you. Referring back to, Mr. Newsome, to a question you responded to earlier. I don't remember the exact context, but basically you said there was good cooperation between the industry and the Commission and they had made a number of recommendations, a fairly small percentage of which you felt that the whole Commission should act on. What is the biggest bone of contention that exists between the Commission and the industry?
Page 44 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. NEWSOME. I don't know that there is just one single factor that you can put your thumb on, although the number of issues that need statutory fixes may be small, those are the bigger issues than the ones that we can fix under our current authority. But I think as we look specifically at those issues, I think they relate just the overall regulatory burden that is placed upon those exchanges, issues such as dual trading, contract approval procedures, payment for order flows, market maker programs. It is a pretty specific list of issues at which the CFTC needs to look that can address decreasing the regulatory burden.
Mr. HAYES. But overall, it would be safe to say that the relationship between the Commission and the industry is reasonably comfortable?
Mr. NEWSOME. Well, I think it probably varies from time to time. I think, as I am the newest in the bunch, and as I have been hungry for information, I have certainly encouraged industry to come to my office to talk with me about what they thought could be changed to further advance the industry, to better the industry. It came to me relatively soon after coming on board, that I thought when you look at the context of our markets in a global context and the fact given our technology, that we are becoming a global marketplace, just like in the agriculture sector that I came from, we are all competing globally now, that we needed to decrease the regulatory burdens so that our exchanges could maintain primacy so that our Congress could maintain as the public policy voice in these financial markets, and I started preaching that relatively early in my term as it became apparent to me.
Now I come from a sector who has traditionally wanted the CFTC to keep the strong hand on the exchanges because, as Congressman Moran pointed out, those things that you are not sure about, you tend to fear the most. And I think most of those in the agriculture sector don't understand very thoroughly the futures market, so there tends to be some distrust there. I think in most cases, that is unwarranted. And I have been trying to sell to the agricultural groups the fact that the exchanges are extremely important to our markets in terms of risk management, price discovery. If we want to maintain the strength in those markets, we are going to have to agree to decrease the regulatory burden. And I firmly believe that.
Page 45 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. HAYES. Thank you, sir. Thank you, Mr. Chairman. Where we are seated at the table shows how long we have been here, Mr. Newsome.
Mr. NEWSOME. Yes, sir.
Mr. EWING. Mr. Ose.
Mr. OSE. Thank you, Mr. Chairman. Is the committee allowing written questions for the panel?
Mr. EWING. Yes, it is.
Mr. OSE. I have four of them and if you have the time, I will submit those in writing and yield the balance of my time to Mr. Thune.
Mr. EWING. Mr. Thune.
Mr. THUNE. I thank the gentleman from California for yielding.
One of the more contentious issues that we are going to have to review in the context of this reauthorization is the status of Shad-Johnson. And, again, realizing this goes back to I think about 1981, but the Commission was a party to that accord at the time, and I am wondering what your thoughts might be with respect to that issue now, and has it served its purpose and does it need to be reviewed, does it need to be modified or changed? Anybody want to take a stab at that?
Ms. BORN. Well, I think that this issue will come before you. There is legal uncertainty concerning equity swaps that needs to be dealt with, and I think it is appropriate for Congress to consider that. And that necessarily implicates the Shad-Johnson Accord because if equity derivatives are going to be permitted over the counter, I think it is appropriate for the Congress to listen to the exchanges, which are saying that they want Congress to consider why equity derivatives, particularly futures on equities and narrow-base stock indices, should not be traded on exchange. Some foreign exchanges are now trading futures on individual equities. For example, I think the Sydney Futures Exchange is doing that. And I know that our exchanges are very interested in having that reconsidered. It seems to me it would be appropriate to reconsider it. If it is reconsidered, I think there is a need, both over-the-counter and on exchange, to make sure that there are prohibitions against manipulation, against fraud, against insider trading, and probably margin requirements that would dove-tail in with the margin requirements for the underlying securities.
Page 46 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. THUNE. Any other Commissioners care to answer?
Ms. HOLUM. I wouldn't disagree with Chairperson Born just said.
Mr. SPEARS. I would agree as well and just add that, as you mentioned, originally it was a short-term fix. It has been in place since 1982, and I think it certainly needs to be revisited and reviewed in this reauthorization process.
Mr. THUNE. Mr. Newsome.
Mr. NEWSOME. I would echo that, Congressman. I am not suggesting that I have an opinion of how to fix it, but I think certainly that this committee needs to reviewI think if you look back at the dialog from the Roundtable, the Joint House-Senate Roundtable a couple of months ago, there were very strong viewpoints expressed at that meeting. Former Chairman Johnson, who is part of the author of the Shad-Johnson Accord, just noted that he thought when they came up with the agreement it was a short-term fix, as Commissioner Spears said, that it would last for a year or two and then be disposed of. So it has been for a long time and that I don't think was the intent.
Mr. THUNE. I think all of you for your answers and would yield back, Mr. Chairman.
Mr. EWING. Mr. Boswell, any questions? Mr. Gutknecht.
Mr. GUTKNECHT. Thank you, Mr. Chairman. And, Mr. Chairman and members of the Commission, I apologize, I was over at a meeting this afternoon, and I missed a good part of your testimony and hopefully my staff can help me catch up.
Before I came to Congress, I was a salesman at one time for a company and the president of the company was the former captain of the Green Bay Packers. And so at our sales meetings, we got to hear a lot about Vince Lombardi. And Vince Lombardi once observed that there are three kinds of people in this world: there are people who make it happen, there are people who watch it happen, and there are people who ask, ''What happened?''
Page 47 PREV PAGE TOP OF DOC Segment 1 Of 4 And you may have already discussed this ad nauseam, but it is a particular concern to me as it relates to the Long-Term Capital Management issue in the hedge funds. We in Congress are sort of in that third category asking, ''What happened?'' And I guess we would like to ask you, first of all, what happened? But more importantly, what can we do in the future? What did we learn from that experience? And what can we say to our constituents and the American people to assure them that it won't happen again? That is the only question I have. It is fairly complicated.
Ms. BORN. Well, it is. And I think the President's Working Group on Financial Markets has gone a long way to answering the question in the report that we all sent up to the Speaker on I think the 28th of April. The President's Working Group on Financial Markets consists of the Secretary of the Treasury, the Chairman of the Federal Reserve Systems Board of Governors, the Chairman of the SEC, and the Chair of this Commission and also has actively working with it a number of other banking agencies and White House economists. And we have a detailed description of what happened with Long-Term Capital Management, what its implications are for the economy and the marketplace and what should be done. We identified
Mr. GUTKNECHT. In a few sentences, could you describe that to me?
Ms. BORN. Yes, yes. My written testimony describes it in a section, which I commend to you. We found that excessive leverage in the financial markets and a lack of information about that excessive leverage were central issues that this raised. We as a group advocated enhanced transparency in the marketplace and specifically recommended that all publicly held companies should report on their exposures to highly leveraged financial institutions.
We also recommended that our Commission, the CFTC, should amend its reporting requirements for hedge funds that are operated by commodity pool operators to require quarterly reports of more detailed financial information, including financial information on market exposures that the hedge funds have and they should be not only provided to us as the regulator, but we should publish those so that the public as a whole has that information. There are a significant number of hedge funds which are not commodity pools and, therefore, do not fall under our regulations. We recommend that Congress adopt legislation that would require those hedge funds to report quarterly, not only to regulators but also to the public so that there is transparency and information available on these very large and highly leveraged entities. There are recommendations that there be stronger prudential controls and risk management techniques by regulated entities, including futures commission merchants that we regulate and securities broker-dealers and others, banking institutions; and that we, as their regulators, should require more in terms of prudential controls and oversee them more assiduously.
Page 48 PREV PAGE TOP OF DOC Segment 1 Of 4 We also recommended that Congress give to the CFTC and to the SEC new powers over the unregulated affiliate of our unregulated entities which may well have significant exposures and the powers that are being asked for essentially reporting and recordkeeping and the ability to go in and audit these unregulated affiliates whose position and financial condition could affect the financial stability of the regulated entities and the financial markets as a whole.
Mr. GUTKNECHT. Mr. Chairman, the red light is on so I will yield back.
Mr. EWING. Do you have a follow-up question on that?
Mr. GUTKNECHT. Well, Mr. Chairman, within all of that, my real concern is, and we have sort of been through this before. But in an era when these transactions occur at the speed of light, and maybe I need to walk through and maybe my staff and perhaps staff from this subcommittee can work through this with me, but it is my understanding from the time that Long-Term Capital started to be in trouble until they reached near meltdown, I don't think it was a quarter. I mean this can happen so fast. I don't know what we can do or what you can do in an era when this thing can turn very quickly. And, as I say, where transactions are occurring at the speed of light, I don't know how we can even have adequate disclosure if you only do it quarterly. I guess that is my real question. And ultimately what we have to answer is how do we as public policy-makers create a system that can somehow provide safety, if you will, in this whole new electronic speed of light environment?
Ms. BORN. Well, I think those are very significant issues that you have put your finger on. And one of the things that the President's Working Group says here is if the extra disclosure requirements and the extra prudential controls and risk management measures do not get us to where we need to be, then we think that additional steps, such as direct regulation of hedge funds and other highly leveraged institutions, should be considered. We also think that direct regulation at that point, not at this point, but if these measures do not do it in terms of reducing the risks in the marketplace, then we should also look at direct regulation of unregulated derivatives dealers.
Page 49 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. Thank you, Mr. Gutknecht.
And to the panel again, my appreciation for your time. We have had a very, I think, interesting afternoon; I think a good exchange. And we may very well be following up with some questions with you and would appreciate your responding to the committee. And thank you, and thank you, Brooksley.
Ms. BORN. Thank you very much, Mr. Chairman, members of the committee.
Mr. EWING. Ladies and gentleman, we will ask the next panel to take their seats: The Honorable Gary Gensler, Under Secretary for Domestic Finance, Department of the Treasury; Ms. Annette L. Nazareth, Director of the Division Market Regulation, Securities and Exchange Commission, and Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System.
Thank you all for being here and thank you for waiting through the first panel, and we appreciate very much having you.
And we will start with you, Mr. Gensler.
STATEMENT OF GARY GENSLER, UNDER SECRETARY, DOMESTIC FINANCE, DEPARTMENT OF THE TREASURY
Mr. GENSLER. Thank you, Chairman Ewing, members of the committee. It is an honor to appear here before you today, and I would like to summarize my statement orally and submit written testimony for the record.
The U.S. derivatives markets perform a critical role in our economy. The innovations and advances of this market also have helped ensure the global leadership of our financial markets and institutions. The dramatic developments in this market, however, have occurred on the basis of rather complex and fragile legal and legislative underpinnings.
Page 50 PREV PAGE TOP OF DOC Segment 1 Of 4 At the request of the Members of Congress, the President's Working Group on Financial Markets is preparing a study of the over-the-counter derivatives market, and it is examining what changes, regulatory or legislative, may be appropriate. Treasury believes that the Commodity Exchange Act needs to be modernized in order to meet current and future demands of the U.S. and global financial markets. And we look forward to working with this committee and Congress in order to resolve important legal certainty issues related to the Commodity Exchange Act.
Derivatives support a higher investment in growth and living standards in the United States and around the world. And the dramatic growth of this market in recent years is a testament to the numerous benefits that derivatives provide for American business. Derivatives can help companies of all sizes, and in all industries, to hedge and manage their risks better. These risks already exist, but they can transfer those risks to other parties.
On the other hand, derivatives can also present certain challenges and issues. The complexity of some derivative instruments leads to issues of appropriateness and risk management for customers and counter-parties. Also, derivatives can allow market participants to assume substantial leverage and may pose issues related to systemic risk.
Treasury believes that Congress should modernize the CEA in order to clarify the status of legitimate products and markets. Because it is possible to interpret the CEA in a very broad manner, jurisdictional and interpretive disputes have occurred among interested parties. These disputes have been accentuated by provisions of the CEA that give the CFTC exclusive jurisdiction over transactions governed by the statute. Moreover, significant changes have occurred in the last 25 years since the original statute was adopted.
I would like to mention a few issues which require congressional action going forward. Firstand I am going to just review threefirst, modification of the Treasury amendment by Congress we believe is needed in order to clarify that certain markets are excluded from the CEA. The Treasury amendment has been the subject of a spate of litigation in recent years and the courts have succeeded in resolving only some of the issues presented. In order to clarify the status of legitimate markets under the Treasury amendment, we believe that Congress should clarify that the term ''board of trade,'' as used in the Treasury amendment, means an organized exchange.
Page 51 PREV PAGE TOP OF DOC Segment 1 Of 4 Second, we believe that Congress should amend the CEA to clarify the legal status of swap agreements. The swap exemption reflects the implicit consensus that has existed for the past 10 years: swap transactions should not be regulated under the CEA. It is our view that swaps are not futures under the CEA and that the CEA, because of its rigidity, is not well-suited to regulation of the institutional swaps market.
Third, the Working Group is considering a special set of legal certainty questions faced by swaps that involve securities governed by the Federal securities laws. We believe that a more permanent legislative clarification of the status of these instruments is necessary.
The President's Working Group on Financial Markets is also addressing, as part of its report on derivatives, a number of other topics related to the derivatives markets. These include issues related to market manipulation, fraud and customer protection, regulatory parity, systemic risks, and international harmonization. We also appreciate that there have been concerns raised by some as to the need to level the playing field between exchange-traded derivatives and over-the-counter derivatives, and we will be examining these issues in the study.
We look forward to working with this committee and Congress, and I would be happy to respond to any questions.
[The prepared statement of Mr. Gensler appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
STATEMENT OF ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, SECURITIES AND EXCHANGE COMMISSION
Page 52 PREV PAGE TOP OF DOC Segment 1 Of 4 Ms. NAZARETH. Thank you, Chairman Ewing, and members of the subcommittee. I am pleased today to appear to testify on behalf of the Securities and Exchange Commission concerning the reauthorization of the Commodity Futures Trading Commission and related issues that affect the SEC. I am also honored today to be in the company of my colleagues from the President's Working Group on Financial Markets. I believe the Working Group has served as an effective forum to address issues that cut across regulatory boundaries.
The Commission works closely and cooperatively with the CFTC, and we support its rapid reauthorization. Although we have interests in a number of issues involving the oversight of derivatives, I will focus today on two subjects. The first is the Shad-Johnson Jurisdictional Accord. The accord is an agreement between the SEC and the CFTC, which Congress codified in 1982 that bans futures on single stocks and on narrow-based stock indexes. It permits trading of broad-based stock index futures that meet certain criteria, subject to the Commodity Exchange Act and under the CFTC's supervision.
The accord was designed to address uncertainties surrounding the regulation of certain securities-based derivative products that stemmed from changes made to the commodity futures laws in 1974. Those changes gave the CFTC exclusive jurisdiction over all futures, whether the underlying commodity was a traditional commodity like pork bellies or a financial commodity like an interest rate.
The accord resolved the uncertainties by dividing between the SEC and the CFTC jurisdiction over the financial instruments. The SEC believes that it has cooperated and worked in good faith with the CFTC and the futures exchanges to facilitate the trading of new and innovative securities index futures contracts.
In the 17 years since the accord became effective, the SEC has contributed to the approval of nearly 70 securities index futures contracts. Although the current regulatory scheme is a bit complicated, the SEC believes that overall the system works.
Page 53 PREV PAGE TOP OF DOC Segment 1 Of 4 The future exchanges now advocate repealing the accord. The SEC is sensitive to the futures markets' desire to expand the base of available futures products. However, we believe that the accord's delicate balance should not be disrupted without the same level of consultation and cooperation achieved by the SEC, CFTC, and their oversight committees when reaching the accord in 1982.
Radical changes to the regulatory landscape should not be undertaken lightly. Any review of the accord must take into account the major disparities between securities and futures regulation. The SEC believes that repealing the accord in the face of these disparities will work to the detriment of our capital markets and investors in those markets. For this reason, the SEC is opposed to the repeal of the accord and trading of single stock and narrow-based index futures at this time. The SEC is particularly concerned that if futures on single stocks and narrow-based indexes are traded under existing futures regulations, investors in such futures would not be afforded the same protections that are provided to investors in the underlying stocks and stock options under the Federal securities laws. For example, in the current futures regime, margin requirements are significantly lower, broad statutory prohibitions against insider trading do not apply. Implied private rights of action for fraud are unavailable and customer suitability determinations are not mandatory.
The proposal circulated by the futures exchanges would only widen the regulatory disparities between futures and securities by scaling back the Federal regulatory oversight of the futures market. This in turn would create tremendous pressure to de-regulate the securities markets. We must not begin a race to the lowest level of regulation, disregarding the negative consequences of eliminating important protections. Although self-regulation plays an important role in maintaining fair and honest markets, it should be an adjunct to effective oversight, not a substitute.
Another area of concern for the SEC is the OTC derivatives market, which has experienced tremendous growth over the past two decades. In part, this growth is due to the significant benefits that OTC derivatives can provide by allowing institutions to isolate and manage risks associated with their business activities. For this market to continue to develop efficiently and effectively, it is essential to provide legal certainty for OTC swaps and other OTC derivative transactions affected between institutional counter-parties.
Page 54 PREV PAGE TOP OF DOC Segment 1 Of 4 I believe that OTC derivative transactions and securities-based swaps should be excluded from the CEA in order to provide the necessary legal certainty for this market. An exclusion would be consistent with the Shad-Johnson Accord's ban against futures on individual securities and would also preserve the SEC's consultation role in securities index futures.
The question of whether additional regulatory safeguards for OTC derivatives are necessary is being considered by the Working Group as a part of its study on the OTC derivatives market. The SEC is actively working with its fellow regulators on that study.
In sum, we believe that repealing the accord and offering futures on single stocks and narrow-based stock indexes would have highly negative consequences for our capital markets. We urge Congress to protect the integrity of these vital markets by preserving the accord. We also believe that at a minimum, steps should be taken to improve the legal certainty of OTC derivative instruments. We will continue to work to develop a coordinated response in this area with the other members of the President's Working Group.
That concludes my testimony, and I would be happy to answer any questions.
[The prepared statement of Ms. Nazareth appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Ms. Nazareth.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. PARKINSON. Thank you, Mr. Chairman. I am pleased to be here today to present the Federal Reserve Board's views on whether it is necessary to modernize the Commodity Exchange Act. The Board believes that modernization of the act is essential. The reauthorization of the Commodity Futures Trading Commission offers the best opportunity to make the necessary change.
Page 55 PREV PAGE TOP OF DOC Segment 1 Of 4 The key elements of the CEA were put in place in the 1920's and the 1930's to regulate the trading on exchanges of grain futures by the general public, including retail investors.
While the objectives of the CEA have not changed since the 1930's, what are now called the derivatives markets have undergone profound changes. On the futures exchanges themselves, financial contracts now account for about 70 percent of the activity and retail participation in most financial contracts is negligible. Outside the exchanges, enormous markets have developed in which banks, corporations, and other institutions privately negotiate customized derivatives contracts, the vast majority of which are based on interest rates or exchange rates.
The Board believes that the application of the CEA to the trading of financial derivatives by professional counter-parties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate because they are settled in cash and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply. For other financial derivatives, for example, futures contracts for Government securities, large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instrument can add to the supply as circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover.
In addition, professional counter-parties simply do not require the kind of investor protections that the CEA provides. Such counter-parties typically are quite adept at managing credit risk and are more likely to base their investment decisions on independent judgment. And if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system.
Page 56 PREV PAGE TOP OF DOC Segment 1 Of 4 In the Board's view, then, significant changes in the CEA are appropriate. In the case of privately negotiated derivative transactions between professional counter-parties, the Board has supported exclusion of such transactions from coverage under the CEA in the past and continues to do so. In these markets, private market discipline appears to achieve the public policy objectives of the CEA quite effectively and efficiently. Counter-parties of these transactions have limited their activity to contracts that are very difficult to manipulate. In general, they have managed credit risks effectively through careful evaluation of counter-parties, setting internal credit limits, and judicious use of netting and collateral agreements. When derivatives dealers have engaged in deceptive practices, the professional counter-parties that have been victimized have been able to obtain redress under laws applicable to contracts generally.
Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for executing or clearing transactions. Such mechanisms could well reduce risks and increase transparency in derivatives markets. However, the development in the United States is being impeded by the specter that the CEA might be held to apply the transactions executed or settled through such mechanisms. Provided the participation is limited to professional counter-parties acting as principals, the Board believes financial derivatives executed are cleared through such centralized mechanisms should nonetheless be excluded from the CEA. The use of such mechanisms would not make these transactions any more susceptible to manipulation than when the transactions are bilaterally executed and cleared, nor will their use impair the demonstrated ability of professional counter-parties to protect themselves from losses from fraud.
Because clearing concentrates and often mutualizes counter-party risks, some type of Government oversight of clearing systems may be appropriate. However, it is not obvious that regulation of such clearing facilities under the CEA would always be the best approach.
Page 57 PREV PAGE TOP OF DOC Segment 1 Of 4 Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the act.
Instead, the Federal Reserve believes that futures exchanges should be allowed to compete in offering such services to professional counter-parties, free from the constraints and burdens of the CEA. The conclusion that centralized mechanisms for professional trading and financial derivatives do not require regulation under the act is valid even if those centralized mechanisms are operated by entities that also operate traditional futures exchanges.
To sum up, the Commodity Exchange Act was designed in the 1920's and 1930's to regulate the trading of grain and other agricultural futures by the general public, including retail investors. Since then, what are now called the derivatives markets have undergone profound changes. Financial derivatives now account for the great bulk of the activity and counter-parties to financial derivatives transactions are predominately institutions and other professions. Financial derivatives are not susceptible to manipulation and professional counter-parties do not need the protections that retail investors do.
The Board believes that privately negotiated derivatives transactions between professional counter-parties should be excluded from the act. Furthermore, the exclusion should apply to centrally executed or cleared financial derivatives, provided that any clearing system is subject to official oversight. Futures exchanges should be allowed to compete as operators of such trading or clearing systems, free from the burdens of the constraints of the act.
Thank you. I would be pleased to answer any questions you might have.
[The prepared statement of Mr. Parkinson appears at the conclusion of the hearing.]
Page 58 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. Thank you, Mr. Parkinson.
Ms. Nazareth, you bring up one of the more controversial issues that we will have to deal with, the Shad-Johnson Accord. There has been earlier testimony today that Mr. Johnson thought that was a short-term, temporary fix to a problem. And in your testimony, I guess if something bothers me about it, it is that it is always get up and say, ''Well, it may impact the markets,'' all the general scare tactics, and maybe that is too strong a word, red flags, whatever you want to call it, and so we back away. This is a very serious concern to the industry, one of the most serious. I guess I wonder what you believe is some of the more middle ground than just say, ''Don't touch it?'' I don't think that is doable. I think you have to look at it, you have to consider it?
Ms. NAZARETH. I wouldn't suggest that all regulation isn't subject to reconsideration. In this particular instance, however, our point is that there are a number of very fundamental differences between commodities regulation and securities regulation. And to simply have the wholesale repeal through congressional action of the Shad-Johnson Accord could in fact lead to very serious consequences to the investing public.
Mr. EWING. Could you give me examples?
Ms. NAZARETH. Yes, the significant differences that I pointed to in my testimony relate to the fact that, for example, the securities laws have very strict prohibitions against insider trading, which the commodities regulatory regime does not. The margin provisions are quite different. Our concern is that any time you have disparate regulatory regimes, you will have sort of a race to the bottom and in this case, the comparable margin requirements for futures would be significantly less than they would be for securities. And certainly in these markets where there has been a general concern about the leverage in our system, and certainly that is something that the President's Working Group spent a fair amount of time on with respect to long-term capital, I don't think it is appropriate to be moving towards a regime that could permit greater leverage, particularly since in this case, I would assume that these products would also be offered to retail investors.
Page 59 PREV PAGE TOP OF DOC Segment 1 Of 4 Another concern that we have and one that is very fundamental to the Securities and Exchange Commission is investor protection and one of the areas where investor protection provisions are quite different relate to customer suitability requirements, which would be optional in the case of futures but mandatory in the case of the securities regime.
That having been said, I think that what we are proposing is that any re-thinking of Shad-Johnson shouldn't be done through sort of wholesale congressional repeal of that accord, which we think has worked very effectively for the last 17 years, but rather through the same kind of thoughtful negotiated process that we went through when the accord was put in place. The SEC and the CFTC negotiated that accord with the assistance of the oversight committees and all the various concerns and issues were hashed out. Obviously, at that time, the determination was that very accord, but I think that is the appropriate means of any sort of further discussion of what to do with the accord.
Mr. EWING. Aren't there things taking place in other markets around the world that are going to impact how reasonable it is for us to keep a hard and firm line on the Shad-Johnson Accord? If other exchanges are allowing that type of trading around the world, won't that competition seep into our world here in the States?
Ms. NAZARETH. I think that activity thus far worldwide has been really quite minimal. I think there are fewer than 20 futures on single stocks that are traded in Australia, for instance, but we haven't had any seepage whatsoever as far as I know.
Mr. EWING. You don't think that has an impact though?
Ms. NAZARETH. No, and I think, again, we also have to look at the differences in the regulatory regimes. The limited amount of foreign activity in this area is under regulatory regimes where there is more harmonization of the securities and commodities regulation and oversight. And here, again, the fear is because we have such disparate regimes, we will be encouraging activity in an area that we don't think provides for sufficient market oversight and investment protection.
Page 60 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. EWING. To Mr. Gensler or Mr. Parkinson, you are part of the President's Working Group, right?
Mr. GENSLER. Yes.
Mr. EWING. And so is this the discussion that you have taken up that you feel there can be some accommodations made to find a more practical way to handle the Shad-Johnson without giving up security and market integrity?
Mr. GENSLER. The President's Working Group does look forward to taking this up in the context of its study. And there is a bit of balancing that we believe would be appropriate. On the one hand, the desires, as expressed by the exchanges, to have the opportunity to trade some of these instruments. But whether that can be done and also promote investor protection, insider trading, the margin rules is the real challenge before us. And I think that is a difficult challenge actually before us.
Mr. EWING. Mr. Parkinson.
Mr. PARKINSON. I guess on this issue our board has not yet taken a position, but I think Chairman Greenspan would welcome the Working Group taking up this issue. And while I can see the reasons why a simple repeal of the accord might be rash and inappropriate, that wouldn't rule out a renegotiation of its terms. Futures on single stocks and narrow stock indexes may require certain regulatory protections that are unnecessary for other financial futures. For example, Ms. Nazareth mentioned the issue of protections against insider trading, which isn't an issue for other futures. But it is not immediately clear why the listing of such contracts on futures exchanges needs to be proscribed. Instead, one could explore whether you could deal with potential adverse effects by applying new regulations that could be enforced by the CFTC and that would have the virtue of eliminating the existing anti-competitive effects of the prohibition on listing those contracts, which may well be impeding innovation to some degree.
Mr. EWING. OK. My time has expired. Mr. Pomeroy.
Page 61 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. POMEROY. Thank you, Mr. Chairman. I want to thank each of you for excellent testimony. To the extent the Working Group can hammer out certain points of resolution on these issues, I can't tell you how helpful we find it. If you deadlock, and we have got to come up with an appropriate mix here, it is not a pretty thought.
I would ask some questions of Mr. Parkinson. I appreciate the chairman scheduling many hearings so members can become more conversant on these issues, and I am really struggling right now to get technically up to speed. Talking about the central mechanism for clearing transactions, do you get to a point where this looks an awful lot like an exchange? If the OTC swap exemption is due to the individually traded nature of the transaction or the individual negotiation nature of the transaction, having a central clearing facility begins to me to look something like an exchange more?
Mr. PARKINSON. Yes, I don't think it is so much the clearing facility, although that may be a means to end. When you ask what is an exchange, I still think the best definition I have seen is one is that the CFTC actually developed in its 1993 swaps exemption where it defined what it called a multi-lateral transaction execution facility, but it might as well be called an exchange. And the definition they use is it is a physical or electronic facility in which all market makers and other participants that are members simultaneously have the ability to execute transactions and bind both parties by accepting offers which are made by one member and open to all members of the facility. Now even if you cleared contracts, there are alreadythe clearinghouse has plans to clear OTC transactions, that would not create an exchange and still you would have counter-parties bilaterally negotiating the deals, making offers that apply only to the counter-party that are open only to the counter-party they are making the offer to and not to all counter-parties in the marketplace. But I think clearing is in fact critical if you are actually going to have an exchange because making the offer open to everyone means you are treating them all as if they have the same credit quality. And the only way to get to that point is to have a clearing system backing the transactions by all the counter-parties. There is a linkage there, but I think clearing is a means to the end of creating an exchange rather than reaching that end by itself.
Page 62 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. POMEROY. Thank you. That was an excellent explanation.
Mr. Gensler, you cited three particular areas where you felt the CEA ought to be modernized. I got two of them and got distracted on the third one. What was the third one?
Mr. GENSLER. Representative Pomeroy, the three areas was one with regard to the Treasury amendment, we believe it is important to clarify that ''board of trade'' means an organized exchange. And I will be glad to come back to that if need be. Two, is to clarify that the swaps exemption, which was adopted in 1993, we think that that would be appropriate to put that into statute as opposed to the current state of play. And, three, as it relates to swaps on securities, that that too should have a more permanent resolution in statute. And right now, there are uncertainties around, shall I say the word Shad-Johnson, there are uncertainties because of how the 1993 exemptions were written into statute. Those three areas, and, if I may, just to come back to your earlier question, as Treasury chairs the Working Group on Financial Markets and we take as one of our challenges, unique roles is to try to form consensus around many market issues to help Congress and maybe sometimes to even help ourselves. It is not always easy with four bank regulatory agencies, two market regulatory agencies, and Treasury to try to agree, but we achieved that goal in the hedge fund report. We look forward to the challenges here, and I think we are actually closer together on some of these issues than it might appear.
Mr. POMEROY. Does Treasury feel Shad-Johnson is a reasonable way of dealing with the issue of derivatives based on securities or do you think that needs some updating as well?
Mr. GENSLER. We do look forward to studying it and trying to reach some consensus in the Working Group. We do think that a more permanent definition of what comes under the act and what doesn't come under the act would be appropriate. And, as I said to the chairman a little earlier, that we wish to address some of these issues around the more narrow-based indices and single stock futures.
Page 63 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. POMEROY. Ms. Nazareth, as you get into the derivatives trading on financial instruments, is it your position that regulatory treatment of the derivative has to parallel regulatory treatment of the underlying financial instrument?
Ms. NAZARETH. I don't know if I would say that across the board, but certainly in the case of securities-based derivatives, certainly our position has been that we have a substantial interest because we have an entire regulatory regime that encompasses securities-based regulation. So in that case, I think we do have an interest. Whether I would say the same thing about a commodity-based future, I don't think Ifor instance, if it was an energy future, I wouldn't have the same opinion.
Mr. POMEROY. Well, financial instruments?
Ms. NAZARETH. Financial instruments, yes. Securities-based derivatives, yes.
Mr. POMEROY. So as to financial instruments, you think the regulatory structure on the underlying financial instrument also is applicable to derivatives in all instances, as to securities in any event? It is a little bit of a question, Mr. Chairman. My time is up. Forget it.
Mr. EWING. Mr. Hayes.
Mr. HAYES. Thank you, Mr. Chairman. Like Mr. Pomeroy, I am struggling to catch up with the technologically advanced nature of this whole argument, and I am pondering your comment earlier about the flawed opinion of the majority. That must have been prior to 1994, right? [Laughter.]
Mr. Gensler, what is your take on the relationship between Treasury and the Commodity Futures Trading Commission Is this all sweetness and light as I seemed to hear previously or do we have a few clarifications yet to be ironed out?
Mr. GENSLER. I think the relationship is strong. I think as a relationship with two parties, it is good to recognize that you might have differences of view. As we worked through the hedge fund study, we were able to clarify them and come to a uniform deal, and I truly do hope that we can do that here. It may be a harder challenge, of course. But we have had discussion on all these topics with the CFTC, and we hope we can help this committee out in forming some basis of recommendation jointly.
Page 64 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. HAYES. Is there any particular area that needs clarification relationship-wise between Treasury and the CFTC?
Mr. GENSLER. I think that the needs for clarification more relate to the regulation of the markets, and while the relationship between the two organizations is strong, there is still uncertainty in statute. As I mentioned earlier, and I apologize these are sometimes obtuse terms, but a board of trade as it is defined in the statute could be you and I talking about and trading some instruments, it is such a broad definition. And we think it is helpful to narrow that to the words ''organized exchange.'' But that really relates to the statute.
Mr. HAYES. So you feel that that can be worked out internally? Hopefully, you don't think we need to help?
Mr. GENSLER. Well, I actually think we would seek your help because it would take legislative action.
Mr. HAYES. Thank you, Mr. Chairman. Thank you, members of the panel.
Mr. EWING. Mr. Boswell.
Mr. BOSWELL. I was following Pomeroy's questioning very much and was enjoying it and was going to claim my time and yield him some of it, but he has departed. So I will just give that back to you in just a moment. But, Mr. Gensler, you have made a couple of comments about on the progress in coming together in some kind of a cohesive approach to all these problems. Would you give us some kind of a guesstimate on just where you think we are, you mentioned one area, but of the four, what would you say? Are we better than halfway there? Apparently not?
Mr. GENSLER. In terms ofI would not wish to pre-judge the outcome, but in terms of timing, we look to work to have a report later this year. In terms of the substance, we are better than halfway there in terms of the dialog and the discussion. It is the compromise and finding solutions together that is the harder challenge.
Page 65 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. BOSWELL. That's what I was actually interested in. Well, thank you. I yield back, Mr. Chairman.
Mr. EWING. Thank you, Mr. Boswell. Mr. Moran.
Mr. MORAN. Mr. Chairman, thank you. The issue of foreign terminals has been one that I understand the CFTC has grappled with. Do any of you, on behalf of either the Working Group or the Federal Reserve, have any suggestions to us as we look at the foreign terminals issue?
Mr. PARKINSON. The Federal Reserve has not taken a position on the foreign terminals issue. Again, some of the principles I think we have enunciated in our testimonythe need to distinguish in terms of the kind of regulatory framework that you need between agricultural futures and financial futures, the need to distinguish between markets where your participants include retail investors versus markets where the participants are exclusively professionalmay well have some bearing on that issue, some implications. But we have not addressed the specific issue, and I will confess we don't understand all the complex issues that may be involved.
Ms. NAZARETH. The SEC is undergoing its own analysis, and I don't think we would presume to say whether or not we agreed with the CFTC's approach at this point. We certainly recognize that it is a very complicated issue and that there are many constituencies on all sides, both domestic and foreign, and it is very, very difficult to please everyone. And I am sure that has been a lesson learned by the CFTC also in this debate.
Mr. MORAN. When you say you are undergoing your own analysis
Ms. NAZARETH. Well, we are going to face the same issues in the securities markets, and we are really at the preliminary stages of having really dialog on the staff level in terms of what to recommend to the Commission in terms of approaches that we could take with respect to foreign terminals being placed in the U.S.
Page 66 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. MORAN. You have not taken any steps, such as the CFTC in the no action letter, you are not that far along?
Ms. NAZARETH. No, no. What we did, we had a concept release in 1997 that raised the issue, but there were probably as many opinions to the concept release as there were comment letters.
Mr. MORAN. Thank you very much. Mr. Chairman, I yield back the balance of my time.
Mr. EWING. Mr. Gutknecht.
Mr. GUTKNECHT. Thank you, Mr. Chairman. I want to revisit this issue that I brought up with the last panel of Long Term Capital Management. We have heard a lot of discussion about it. And I would also add my voice to the opinion offered by Mr. Pomeroy that I hope you guys can come to some kind of a consensus because when I first saw this on the agenda back in January that this was going to come up and we would be talking about it on this subcommittee, I didn't think it was a particularly complicated issue or I didn't think it would be controversial. I now no longer share that view. I think this is a very difficult issue and very complicated. Really, it will take the wisdom of Solomon and the speed of Mercury to keep up with this thing.
But I want to come back to the Long Term Capital issue because in some respects I think it illustrates part of the problem we have. And several, and I think a couple of you have mentioned the issue of disclosure, but I am not exactly sure how that is going to work. Now if we go back to the basic notion of what is going on here. And Mr. Boswell and I share several things in common, one of which is we are both auctioneers. And one of the great things about the auction business and where you have got a live auction and you have got real buyers, real sellers, and people can see at least some of the toothpicks moving in people's mouths and some of the other signals going on, at least there is a level of transparency there so that everybody can see what is going on. And even on the floor, in the pits of some of these commodity exchanges, there is live action, and people can see who is bidding and who is doing what. You really enter a whole new dimension when you start talking about electronic trading. And I know that happens in the New York Stock Exchange, but there are tickers; there are other ways; there are lots of eyes watching what is going on in the market all the time.
Page 67 PREV PAGE TOP OF DOC Segment 1 Of 4 When you get into some of these fairly sophisticated derivatives and hedge funds, and so forth, how do you propose that there is going to be that level of transparency? How can we have more eyes watching what is really happening so that we don't wind up in a situation where you wind up in a virtual meltdown that has happened electronically and people didn't know what was going on until it was almost too late? I am still trying to figure out how this transparencyreporting quarterly to me, I wouldn't say it is worthless, but I don't see the value of that. It is like reporting stock quotes quarterly. I mean it doesn't tell you much.
Mr. GENSLER. Maybe if I can try to address that. The Working Group in the hedge fund study felt there had been a market breakdown, that market discipline, risk management standards had broken down, not only around Long Term Capital but some of the financial crises in the last 18 to 24 months. And so we had a series of recommendations to address transparency and disclosure and promoting better risk management practices at financial institutions. Only one of those proposals being that hedge funds quarterly publicly disclose their financials. And the thought is that, by publicly disclosing their financials, it will push back, have some sort of governor or mechanism to push back on the excess leverage that is taken on. But it is not the only recommendation that we have promoted. We have promoted recommendations of more transparency and disclosure by banks and securities firms, public disclosure, more and better risk management standards, and even updating of capital standards, the Basle Capital Accord. So it is our belief that through this series of recommendations that the private markets will push back on excess leverage. It was not to be something, as you point out, to disclose trade by trade the activity on an exchange.
Mr. GUTKNECHT. But do you honestly believe that quarterly reporting is enough? I mean mutual funds you can look up everyday.
Mr. GENSLER. Well, we believe it was important to have more than that and that's why we had a series of recommendations, this just being one of those recommendations. In fact, we bracketed in I think eight key areas of recommendations and this was only one of them. And so I think we would agree with you that that alone would not be enough.
Page 68 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. GUTKNECHT. Mr. Parkinson, you are representing the Federal Reserve. Because ultimately what happened with that, as I understand it, is the chairman of the Federal Reserve brought some people together and more or less discussed what was wrong and what was going to be done about it, and that implies in some respects, we were all participants in that. And what are some of the observations from the perspective of the Federal Reserve, what went wrong and where we go from there?
Mr. PARKINSON. Well, first, I think we see what our role was in that incident as facilitating meetings by LTCM's creditors and counter-parties in which they mutually agreed on a course of action, which was in their collective and individual self-interest which was to re-capitalize the firm rather than letting it go into bankruptcy and suffer the losses they would otherwise have suffered in liquidating their positions and replacing their contracts with LTCM.
In terms, again, I think our overall view of this situation and what needs to be done, obviously, we don't want people coming to the Fed and asking us to help them out sorting out their problems. We would much prefer that private market discipline solve these problems, and I think the thrust of the Working Group's report is that the solution to the problem of excess leverage, which we saw in LTCM's case is primarily a matter of enhancing that private discipline. The creditors and counter-parties making sure that they do not extend excessive amounts of credit that allow, that are critical to that party achieving the leverage that it did, that threatened the markets in the way that it did. And that is the primary and most important part of the response.
I think to get back to your last question, for example, if you say is quarterly enough? Well, we don't think it is enough for the counter-parties. If a bank that we supervised is dealing with a hedge fund and they told us that in assessing the credit worthiness of that hedge fund, they were relying on the quarterly public information, we would say that that is not sufficient. That is unsafe and unsound. You need to be having an ongoing dialog with that counter-party and having an ongoing exchange of information at a much higher frequency. So I guess the question is in terms of the quarterly frequency, is that frequently enough for whom? For the counter-parties, no. Perhaps no for the investors in the hedge fund. But for the general public, perhaps that is frequently enough.
Page 69 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. GUTKNECHT. OK, thank you.
Mr. EWING. Mr. Chambliss.
Mr. CHAMBLISS. Thank you, Mr. Chairman. Mr. Gensler, I want to direct this to you and, Mr. Parkinson, I would also like you to comment on this if you will, please? Mr. Gensler, in his testimony before the Senate Agriculture Committee on June 30, 1998, Deputy Treasury Secretary Larry Summers testified that advocates of greater regulation of off exchange derivatives bear the burden of proof that such regulations are needed when he said, ''To date, there has been no clear evidence of a need for additional regulation of the institutional OTC derivatives market, and we would submit that proponents of such regulation must bear the burden of demonstrating that need.'' First of all, do you agree with Mr. Summers' statement. And also, since he is your boss, I guess I know the answer to that, but I would still like it on the record. [Laughter.]
Second, do you agree that these are the principles that will guide the Treasury as it considers the possibility of any new regulation? And, Mr. Parkinson, I would sort of like the Fed's position on that too, please?
Mr. GENSLER. I am glad to respond and answer in that positively, unambiguously I concur with Larry Summers on this.
Mr. CHAMBLISS. You may keep your job then.
Mr. GENSLER. Thank you. Thank you. But I think they are good parameters to guide us. This market, while large, it is $70 trillion of worldwide derivatives, shows the vibrancy and the importance of this market for all sorts of participants to hedge their risks and transfer risks. That could be a grain producer transferring the risk, it could be a homeowner that is able to borrow more cheaply because their mortgage that they are borrowing has mortgage derivatives behind it. The homeowner never even sees those derivatives, but gets cheaper funding for their home. That large and vibrant market is part of, I believe, the American success. And we should recognize that and put the burden on those who are suggesting changes and further regulation, put the burden on them before we tamper on some of the successes of this marketplace for the economy.
Page 70 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. CHAMBLISS. Mr. Parkinson.
Mr. PARKINSON. Well, Larry Summers is not my boss, but that quotation sounds a lot like my boss. So I think I can wholeheartedly endorse that.
Mr. CHAMBLISS. OK. And I will direct this to whoever wants to answer it, the SEC has suggested excluding swaps from the Commodity Exchange Act in an effort to provide legal certainty for these products. And if that should happen, who would regulate these transactions? Would the SEC step in and regulate them?
Ms. NAZARETH. I think, as you know, the President's Working Group will be studying over-the-counter derivatives and as part of that study, we will be discussing what kind of oversight, if any, would be appropriate for over-the-counter derivatives, which would include securities-based swaps. When we are asking for the exclusion from the Commodity Exchange Act, we are not asking for jurisdiction over those products at this time.
Mr. GENSLER. If I might just add, currently there is some ambiguity and uncertainty in how the act is written and how the exemption is written. And that uncertainty, we believe, does not promote the economy as much as clarifying it, taking the uncertainty out of the statute and therefore promoting the markets. I think probably all three of the participants up here and their agencies would concur on this approach, on clarifying that legal uncertainty. And that probably would be, if there was one overall theme from Treasury, that would be the theme that I would hope that we have left here with you today, which is to clarify and lessen that uncertainty in these markets, these such important and vital markets.
Mr. CHAMBLISS. Thank you, Mr. Chairman.
Mr. EWING. Thank you all for your cooperation. I guess I can anticipate that the President's Working Group will be considering some of these contentious issues that are involved in the reauthorization. Mr. Gensler, when could we anticipate that we might have some information?
Page 71 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. GENSLER. As I think I mentioned earlier to a question, we look forward to completing our study later this year. As we have had very good dialog, we also have a change in leadership at the CFTC, and so we recognize and respect that that may also influence some of the timing on this.
Mr. EWING. Well, if you care to take the message back, I would encourage sooner rather than later so that we have the opportunity to consider it in the work that we need to do here. And we look forward to working with you in any way we can to expedite your deliberations and need your help and look forward to it.
Mr. GENSLER. We thank you for holding this hearing, and we think that your attention to this is very helpful.
Mr. EWING. The hearing is adjourned.
[Whereupon, at 5:55 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
[Material submitted for incluision in the record follows:]
Testimony of Brooksley Born
Mr. Chairman and members of the subcommittee, I am pleased to be here this morning to testify concerning issues that Congress should consider as it begins the process of reauthorization of the Commodity Futures Trading Commission. This is an appropriate time to undertake a comprehensive review of the Commodity Exchange Act to assure that it continues to provide an effective framework for Government oversight of our rapidly changing futures and option markets.
It is a time of profound change in the futures industry. Electronic trading systems are replacing floor trading at exchanges around the world. The ultimate role of intermediaries in these new systems is not yet clear. Moreover, instantaneous international communication and transactional capabilities are creating truly global markets. Domestic exchanges and industry professionals are eager to offer their products and services to customers abroad, while foreign exchanges are just as eager to offer their products to U.S. customers. While futures exchanges are grappling with these technological developments, the number and types of derivative products offered over-the-counter continue to mushroom even as the volume of transactions in that market increases exponentially. Furthermore, many OTC derivatives market participants are expressing an interest in adopting trading and clearing systems that would cause the OTC market to resemble exchange markets. In the face of these developments, it is important to review the CEA and the Commission's current regulations to modernize and to streamline oversight of these critically important markets.
Page 72 PREV PAGE TOP OF DOC Segment 1 Of 4 TECHNOLOGICAL CHANGE
Technological advancements are no doubt the single biggest source of change in the industry. In the last few years, a number of foreign futures exchanges have abandoned their trading floors in search of faster and cheaper trade executions through directly accessible electronic trading systems. Exchanges that once physically existed only overseas now can be accessed from personal computers anywhere in the worldincluding the United States. Some foreign electronic exchanges now want direct electronic access to U.S. traders. In response to this development, the Commission recently issued a proposed new rule to allow foreign exchanges to place electronic terminals or automated order routing systems in the United States. This rulemaking tackles cutting-edge technological issues. It also addresses the difficult issue of how best to accomplish the statutory mandate of protecting U.S. investors in an increasingly global market. The proposal seeks to avoid imposing undue or duplicative regulatory requirements on exchanges by taking into account, where appropriate, the foreign regulation of the exchange seeking access to the U.S.
U.S. exchanges are responding to foreign competition and technological developments by improving their electronic trading systems and successfully integrating electronic and open outcry trading in some contracts. The Chicago Mercantile Exchange pioneered this innovation when it offered concurrent electronic and open outcry trading of the e-mini version of its S&P 500 futures contract. That development also opened the way for some firms to offer on-line trading access to the E-mini on Globex2, CME's electronic trading system. The Chicago Board of Trade also now features concurrent electronic and open outcry trading in many of its financial contracts.
New, fully electronic U.S. exchanges are being launched. In September 1998, the new Cantor Financial Futures Exchange became the first fully electronic-based U.S. exchange. The Commission recently permitted CFFE to implement rule changes which provide for direct electronic access by members and certain other traders. Specifically, CFFE's new direct-access rules allow CFFE clearing members and their affiliates, Coffee, Sugar & Cocoa Exchange members, New York Cotton Exchange members, and CFFE members designated as market makers to enter orders for proprietary and customer accounts through terminals provided by CFFE. In addition, authorized customers of CFFE clearing members are able to access CFFE products, subject to position limit and credit checks, through an interface with their clearing members.
Page 73 PREV PAGE TOP OF DOC Segment 1 Of 4 In addition to its innovative trading system, CFFE represents a novel alliance between the NYCE, which performs all of CFFE's regulatory responsibilities, and Cantor Fitzgerald Securities, which performs all of the trade execution functions. While CFFE memberships are held by members of NYCE and CSCE, CFFE has significantly reduced the need for intermediaries by making trading privilege licenses available to market participants fully guaranteed by clearing members for the relatively modest sum of $2,000. CFFE is owned 90 percent by NYCE and CSCE members and 10 percent by NYCE and CSCE themselves.
Another aspiring U.S. exchange, FutureCom, has not yet been designated as a contract market in any commodity, but has an application pending before the Commission to become the first Internet-based futures exchange in the world. FutureCom, as proposed, would be structured unlike any existing exchange. All its members would be clearing members, would have their trading accounts held by the exchange and would be directly linked to the trading system. Members' account balances and positions would be updated in real-time, and members would be prevented from entering any orders for which they did not have the requisite margin in their accounts. Each FutureCom member would be directly financially responsible to FutureCom for its own trades. FutureCom would not be owned by its members, as all U.S. exchanges other than CFFE are, but would instead be organized as a limited partnership among the organizers of the exchange and would be run on a for-profit basis.
FutureCom's use of the Internet and its membership structure would create a new model for participation in U.S. futures exchanges. Using the Internet to transmit trade and financial information would facilitate direct access by the public and would result in the elimination of a significant role for intermediaries. Since each FutureCom member would provide for its own access to the Internet and thus to FutureCom, functions traditionally performed by a futures commission merchant would not be needed by a member to access and trade on FutureCom.
The radically different proposed structure of FutureCom has presented the Commission with the challenge of how best to apply laws and regulations designed for an intermediated, open outcry trading environment to an electronic direct access system. The Commission staff has been working with FutureCom to determine whether it can provide the necessary protections for the trading public and the market itself in light of the unique aspects of the proposal. There are still unresolved issues surrounding FutureCom's application, and therefore it has not yet been presented to the Commission by the staff. However, it is inevitable that an exchange, whether based in the U.S. or abroad, will eventually emerge that uses the Internet as its communication medium and offers direct access to customers around the globe.
Page 74 PREV PAGE TOP OF DOC Segment 1 Of 4 While automated trading systems may diminish certain regulatory concerns that the Commission has relating to trading abuses in open outcry trading, automated trading raises other regulatory issues such as system capacity and security which are not applicable to the open outcry environment. We currently have insufficient experience with electronic systems accurately to identify all of the risks they may pose.
As seen in the CFFE and FutureCom examples, technology is contributing to ongoing changes in exchange governance and organization. New exchange ownership structures are emerging that are intended to improve exchanges' ability to engage in effective strategic planning and implementation. Membership organizations are being abandoned by some foreign exchanges in favor of public stock ownership, raising serious issues concerning whether such demutualized, profit-oriented exchanges can adequately continue to perform the self-regulatory role exchanges traditionally have played. Some U.S. exchanges have stated that they too are exploring whether such an ownership structure is feasible. In the face of these developments, both Congress and the Commission need to examine whether the CEA and Commission regulations, which have their underpinnings in self-regulatory membership organizations, remain sufficient and appropriate for these alternative governance structures.
Moreover, as technological enhancements fuel the development of direct access electronic trading systems, investors increasingly will be able to gain access to markets without having to trade through an intermediary, and the role of intermediaries may diminish. The need for fitness standards and customer protection measures which underlie the Commission's current registration scheme for commodity professionals may become less important with greater direct access and diminished discretion associated with automated trading. However, other issues such as whether direct access trading is appropriate for all types of investors need to be examined. Congress and the Commission need to consider whether the statutory and regulatory frameworks that have served well for intermediated trading need to be adapted to direct access electronic trading.
Page 75 PREV PAGE TOP OF DOC Segment 1 Of 4 During the past 3 years the Commission has devoted considerable resources to addressing the difficult and rapidly evolving regulatory issues associated with technological innovation in the industry. In addition to its work on the matters described above, the Commission continues to make progress in permitting electronic media to be used for certain types of recordkeeping, disclosure to customers, filings with the Commission, and communications by industry professionals both with the Commission and with their customers. Certainly many rules still need to be modified to adapt to the changing nature of the industry. Congress also needs to address the implications of technological innovation as it considers reform of the CEA. Any changes to the CEA and the regulatory framework, however, must also ensure that the Commission has sufficient regulatory tools to protect against fraud, customer abuse, market manipulation and financial disruption in this new electronic age.
Although Congress may very well need to adapt the statutory framework to the changing nature of futures trading, significant relief may be achieved through Commission rule amendments. The Commission is committed to reducing regulatory costs and burdens on our exchanges and market participants. The Commission has undertaken a number of major regulatory reform initiatives to modernize and streamline the regulatory regime it administers. Many of these initiatives resulted from industry proposals that were first raised during the legislative debate that occurred in this subcommittee 2 years ago. Some of the many proposed and final rules issued in the last 2 1/2 years include:
Rule amendment adopting harmonized financial reporting requirements for CFTC registrants who are also registrants with the Securities and Exchange Commission. (62 Federal Register 4,633 (January 31, 1997).)
Rule amendments to permit filing by large traders of CFTC Form 40, Statement of Reporting Trader, only when requested by the Commission rather than annually. (62 Federal Register 6,112 (February 11, 1997).)
Page 76 PREV PAGE TOP OF DOC Segment 1 Of 4 Rule amendments establishing streamlined fast-track procedures for processing contract market designation applications (62 Federal Register 10,434 (March 7, 1997)) and exchange rule amendments. (62 Federal Register 10,427, 10,434 (March 7, 1997).)
Rule amendments permitting FCMs to file required financial reports with the Commission electronically. (62 Federal Register 10,441 (March 7, 1997).)
Rule amendments allowing commodity trading advisers and commodity pool operators to file required disclosure documents with the Commission electronically. (62 Federal Register 18,265 (April 15, 1997).)
Rule interpretation permitting streamlined procedures for allocation of customer orders which are bunched for execution by CTAs. (62 Federal Register 25,470 (May 9, 1997).)
Rule amendments permitting FCMs to deliver monthly statements, trade confirmations and other account statements solely by electronic media to customers who consent to electronic transmission in lieu of receiving paper documents. (62 Federal Register 31,507 (June 10, 1997).)
Rule amendments authorizing CTAs and CPOs to provide risk disclosure documents to their consenting customers via electronic media. (62 Federal Register 39,104 (July 22, 1997).)
Rule amendments to eliminate Commission-mandated risk disclosure for certain categories of financially sophisticated customers. (63 Federal Register 8,566 (February 20, 1998).)
Rules establishing a pilot program to lift the ban on the trading of agricultural trade options. (63 Federal Register 18,821 (April 16, 1998).)
Approval of innovative exchange programs such as NYMEX's market maker program (63 Federal Register 27,058 (May 15, 1998)) and NYMEX's proposed exchange of futures for swaps (Commission Order, January 7, 1999).
Page 77 PREV PAGE TOP OF DOC Segment 1 Of 4 Rules to eliminate the short option value charge against the capital of FCMs. (63 Federal Register 32,725 (June 16, 1998).)
Rules to permit futures-style margining of commodity options. (63 Federal Register 32,726 (June 16, 1998).).
Rule amendments granting increased flexibility concerning exchange trading hours. (63 Federal Register 33,848 (June 22, 1998).)
Rule amendments to permit post-execution allocation of bunched orders of sophisticated customers of a CTA or investment advisor. (63 Federal Register 45,699 (August 27, 1998).)
Rule amendments to modernize the Commission's rules relating to procedures for administrative enforcement proceedings. (63 Federal Register 55,784 (October 19, 1998).)
Rule amendments allowing two-part disclosure by CPOs to customers. (63 Federal Register 58,300 (October 30, 1998).)
Rule amendments establishing a streamlined procedure for firms or persons seeking no-action determinations, exemptions and interpretations from the Commission's staff. (63 Federal Register 68,175 (December 10, 1998).)
Rule amendments to ease the Commission's speculative limit rules. (64 Federal Register (May 5, 1999).)
Proposed rule amendments to change the Commission's recordkeeping requirements to permit expanded use of electronic storage media. (63 Federal Register 30,668 (June 5, 1998).)
Proposed rules to streamline further the contract market designation process under Commission Guideline 1. (63 Federal Register 38,537 (July 17, 1998).)
I hope that members of the industry will continue to provide the Commission with additional suggestions for improving its regulatory framework.
Page 78 PREV PAGE TOP OF DOC Segment 1 Of 4 OTC DERIVATIVES MARKET AND HEDGE FUNDS
Another challenge facing the industry and financial regulators today is the rapid growth of the OTC derivatives market. The volume of trading in that market has exploded in the last 5 years and now is estimated by the Bank for International Settlements to be $70 trillion in notional value worldwide. In addition, this virtually unregulated market has grown in diversity with the development of a multitude of new products, entry by new market participants and increased interest in new market mechanisms. Last year the Commission issued a concept release to initiate a study of the changes in the OTC derivatives market and of whether the Commission's current regulation of that market requires updating in light of significant market developments. Many of the regulatory issues identified in the concept release became front-page news last September when a very large hedge fund, Long-Term Capital Management L.P., nearly defaulted on $1.25 trillion in notional value of exchange-traded and OTC derivatives contracts.
The LTCM episode demonstrates the unknown risks that the OTC derivatives market may pose to the U.S. economy and to financial stability around the world. It also illustrates the lack of transparency, excessive leverage, and insufficient prudential controls in this market as well as the need for greater coordination and cooperation among domestic and international regulators. I welcome the heightened awareness of these issues and believe it is critically important for all financial regulators to work together closely and cooperatively on them. We must address whether there are unacceptable regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants.
The President's Working Group on Financial Markets, which consists of the Secretary of the Treasury and the Chairs of the Federal Reserve System Board of Governors, the SEC and the CFTC, is currently working on a study relating to the OTC derivatives market and has just completed a study of hedge funds and other highly leveraged institutions. As a member of the President's Working Group, I am pleased to endorse the recommendations contained in its report on hedge funds entitled ''Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,'' transmitted to the Speaker of the House of Representatives on April 28, 1999. The report identifies as a central issue excessive leverage in the financial system and the lack of available information about it. The report provides important recommendations about each of the four main issues raised by the near insolvency of LTCMthe need for increased transparency, the need to eliminate excessive leverage, the need for better prudential controls and the need for enhanced international cooperation and harmonization of regulations.
Page 79 PREV PAGE TOP OF DOC Segment 1 Of 4 The report recognizes the critical importance of heightened transparency in the markets by recommending greater disclosure and reporting by hedge funds. It calls for all hedge funds to report detailed financial information, including information about their exposure to market risk, on a quarterly basis. For hedge funds that are CPOs, the report recommends that such reporting should be accomplished through amendments to CFTC reporting rules. The Commission staff is preparing recommendations for rule amendments to require such reporting by CPOs. For hedge funds that are not CPOs, the report recommends that Congress should enact legislation that authorizes mechanisms for such disclosure. The hedge fund financial information would be provided not only to regulators but also to the public. It would thus be available to hedge fund investors, counterparties and creditors to assess the creditworthiness of the hedge fund. It would also be available to regulators and market participants to help assess market integrity and financial stability. In addition, the report recommends that all public companies should be required to report publicly their exposure to highly leveraged financial institutions.
The report also emphasizes the need for enhanced risk management efforts by regulated entities such as FCMs and enhanced oversight of those efforts by regulators. It endorses the view that prudential supervisors and regulators should promote the development of more risk sensitive approaches to capital adequacy.
In addition, the report recommends that regulators should have expanded risk assessment powers relating to unregulated affiliates of securities broker-dealers and FCMs. To effect this recommendation, the report recommends a change to the CEA to grant the CFTC expanded reporting, recordkeeping, and examination authority for material unregulated affiliates of FCMs. This authority would provide the CFTC with needed information about the potential risks that an unregulated affiliate might pose to its related FCM and to the financial system. I commend this recommendation to the subcommittee and urge that enabling legislation should be adopted.
Page 80 PREV PAGE TOP OF DOC Segment 1 Of 4 Finally, the report recognizes the need for international cooperation among regulators to encourage the adoption and implementation of international standards governing hedge funds and credit exposure to them. The President's Working Group also agreed that, if these measures prove to be inadequate, serious consideration should be given to the direct regulation of hedge funds and other highly leveraged institutions, including such measures as capital requirements. In addition, direct regulation of derivatives dealers should be considered and indeed is being currently studied by the President's Working Group in the context of its ongoing study on the OTC derivatives market.
Although it is appropriate to await the recommendations of the President's Working Group study on OTC derivatives before endorsing additional specific changes to the CEA, it is clear that developments in the OTC market have implications that may merit further changes to the statutory framework. As mentioned earlier, some OTC derivatives market participants are now interested in the development of automated trading and clearing systems that would closely resemble the regulated exchange markets. For example, the Commission recently granted a petition of the London Clearing House to allow an exemption from the Commission's regulations which would permit clearing of swap transactions for the first time. LCH plans to establish ''SwapClear,'' a proposed facility for clearing swap transactions that otherwise satisfy the terms and conditions for swap transactions imposed by the Commission's regulations. The Commission's order exempts certain swap agreements submitted for clearing through SwapClear from most provisions of the act and Commission regulations and provides a similar exemption to specified persons who engage in certain activities with respect to such agreements. Such swaps clearing operations may provide substantial benefits to the OTC derivatives market, including imposing controls on excessive extensions of credit, reducing counterparty credit risk and increasing transparency.
As the OTC derivatives market evolves to resemble traditional futures and option exchanges, new regulatory concerns about the market will arise, and increased parity in treatment of the OTC and exchange markets will be necessary. Both Congress and the Commission need to grapple with the question of where such parity is appropriate and how it may best be achieved. One important principle should inform this review. CFTC oversight of derivatives markets traditionally has been exercised according to the nature of the market, the market participants and the products involved. This approach to market oversight creates consistency of regulation without regard to the entity trading the product. It also fosters market and product expertise by the regulator that can then be applied even-handedly to all market participants. A market-based approach also allows the regulator to address comprehensive market issues such as market integrity, manipulation, fraud, and systemic risk.
Page 81 PREV PAGE TOP OF DOC Segment 1 Of 4 The benefits of market regulation apply equally to exchange-traded and OTC derivatives. While the nature of and participants in the OTC derivatives market may warrant a different degree or kind of regulation from the exchange-traded derivatives markets, the size and nature of the OTC market create a potential for systemic financial risk. Moreover, as OTC market participants seek to clear swaps and express interest in various forms of screen-based trading, the distinctions between exchange-traded and OTC derivatives markets begin to blur.
Entity-based supervision of OTC derivatives dealers alone is not sufficient to oversee this market. While such supervision is important to the safety and soundness of many of the large dealers, many participants in the OTC derivatives marketincluding many hedge funds and other highly leveraged institutionsare not subject to Government oversight. Equally important, an entity-based regulatory approach does not provide oversight of the market generally, which may be particularly dangerous in a market that is currently as large and opaque as the OTC derivatives market. Market regulation such as that conducted by the CFTC and the SEC is an important component of market oversight and public protection. Institutional supervisors focus on the trees; market regulators see the forest. Both are needed to protect important public interests.
As Congress examines the CEA, it should give careful consideration to the statutory treatment of equity derivatives. Greater legal certainty is needed for equity swaps, and the SEC and many swaps dealers have argued that they should be exempted from the CEA. If that were to be done, an appropriate regulatory framework for such activity would need to be developed. It would seem reasonable to include prohibitions against fraud, insider trading, and manipulation and margin requirements. In addition, if Congress were to take such action with respect to OTC transactions in equity derivatives, it should seriously consider permitting futures on equity securities to be traded on the futures exchanges.
Congress should also provide the Commission with clear and unequivocal enforcement authority to pursue off-exchange foreign currency fraud imposed on members of the retail public, which has reached epidemic proportions.
Page 82 PREV PAGE TOP OF DOC Segment 1 Of 4 REAUTHORIZATION PROVISION
Finally, as Congress considers changes to the CEA, it should give serious consideration to removing the provision of the act that requires periodic reauthorization of the Commission. The Commission will celebrate its 25th anniversary next year, and there can no longer be any doubt that it is necessary and appropriate to have an independent regulatory agency overseeing the Nation's futures and option markets. The periodic reauthorization process consumes an enormous amount of time and resources by both the industry and the Commission that could otherwise be focused on business and regulatory innovation. While I believe strongly in the importance of Congressional oversight of the Commission, that oversight is and should be exercised routinely. Congress does not need a reauthorization provision to change the CEA whenever it believes it is necessary to do so.
Thank you for the opportunity to share my views concerning important matters confronting the U.S. futures industry, the CFTC, and the Congress which should be considered during the reauthorization process. On a personal note, this is my last appearance before this subcommittee as Chairperson of the CFTC. My last day in office will be June 1, 1999. I would like to thank you, Mr. Chairman, and the members of the subcommittee for your courtesy and cooperativeness during my tenure and to express how much I have enjoyed working with you. I would be happy to answer your questions.
Statement of David Spears
Mr. Chairman and members of the submmittee, I appreciate the opportunity to testify here today as you continue to gather information in preparation for CFTC reauthorization. My remarks, which represent my own personal views and not the official position of the CFTC, will be rather general in nature. As you know, the Commission expects to be joined very shortly by two new members, including a new chairman. When that new membership is in place, I expect our top priority will be to reach consensus on formal agency positions regarding a wide range of specific reauthorization issues. For now, I would like to share with you a few general thoughts on the inherent challenges of this reauthorization process and some of the policy considerations that are critical to meeting those challenges.
Page 83 PREV PAGE TOP OF DOC Segment 1 Of 4 In my view, the primary challenge for today's financial regulator is keeping pace with changes in the industry it regulates. This is especially true in the CFTC's regulatory arena, where recent years have seen globalization of the financial markets, remarkable new electronic trading technologies, a bewildering array of new products, and challenges to U.S. futures exchanges from both overseas and over-the-counter (OTC) competitors.
As we take up the challenge of amending the CEA, I believe this committee's most difficult task will be finding the appropriate balance between competing policy considerations. I believe the process of regulation should be a public/private partnershipa cooperative system that enables the U.S. futures industry to grow and prosper. I recognize the industry's legitimate concern over the competitive challenge they face from foreign markets and OTC competitors. I understand the need to reduce unnecessary regulatory burdens so they can meet that competition on a level regulatory playing field. But where will that level be? Achieving regulatory parity will entail difficult policy choices involving the structure of financial security, market integrity, and customer protection standards that have been the cornerstone of U.S. futures regulation for over 70 years.
I recognize that the sophisticated, professional traders who account for the vast majority of financial futures volume do not need the same level of regulatory protections as smaller traders. However, we cannot forget that granting regulatory relief to those market professionals could lead to a two-tiered market structure. The second-tier, residual market, which would surely include a greater proportion of the agricultural contracts, could face diminished price discovery capability and proportionately greater regulatory costs.
I realize that OTC markets need legal certainty; and I strongly support CFTC cooperation, as part of the President's Working Group on Financial Markets, to help provide that certainty. However, as noted in the Working Group's Hedge Fund Report, efforts to provide legal certainty cannot ignore such factors as potential systemic risk from the activities of highly leveraged institutions.
Page 84 PREV PAGE TOP OF DOC Segment 1 Of 4 I recognize that it makes no sense to saddle electronic trading systems with rules originally designed for open outcry trading pits. Over half of the CEA's requirements for exchanges do not even apply to electronic systems. But switching to electronic trading will not turn everyone in the marketplace into a saint. Somebody will still need to take responsibility for protecting customers in the electronic marketplace from abusive trading practices and fraud.
As Congress tackles these difficult policy choices, I would like to stress one additional point. The Commission, U.S. futures exchanges, and market participants all need and deserve a CEA that is flexible enough to allow for appropriate regulatory responses to changing circumstances. Let me give you an example of the benefits of flexible statutory authority. Last June, the Commission issued rules for an agricultural trade options pilot program. Those rules were drafted in the immediate aftermath of the hedge-to-arrive crisis. In my view, an understandable desire to avoid similar problems with agricultural trade options resulted in a program with too many regulatory bells and whistles. The resultexactly nobody signed up for the program. The good news, however, is that our staff is now hard at work drafting amendments to make the pilot program more user-friendly. We can do this because the CFTC's broad statutory authority over options gives us the flexibility to adjust our regulations as needed. Also, when implementing these or any regulatory changes, the agency should apply a rigorous cost-benefit analysis. Bear in mind, however, that both the costs and the benefits of futures regulation are very hard to measure.
CFTC reauthorization has always been a difficult and controversial process. The stakes are too high to expect anything else. But reauthorization does not have to be a disagreeable or antagonistic process. I believe the best results can be achieved with an open mind and a cooperative attitude. In that spirit, I have held numerous meetings with representatives of the exchanges, the brokerage community, and farm organizations aimed at better understanding the competing interests and seeking consensus where possible. I plan to continue that process as the reauthorization debate continues. I commend this committee for getting an early start on reauthorization issues, and I look forward to similar cooperative efforts with the committee as well. I am confident that these efforts will result in a reauthorization bill that will enable the CFTC and the markets it regulates to meet the challenges of the 21st century.
Page 85 PREV PAGE TOP OF DOC Segment 1 Of 4 Thank you. I would be happy to answer any questions you may have.
Testimony of David D. Spears Before the Senate Committee on Agriculture, Nutrition and Forestry, May 5,1999
Mr. Chairman and members of the committee, I am pleased to appear on behalf of the Commodity Futures Trading Commission to discuss the Commission's pilot program for agricultural trade options. Since I am the chairman of the Commission's Agricultural Advisory Committee and the CFTC representative on USDA's Risk Management Education Steering Committee, Chairperson Born asked me to represent the Commission here today.
In order to give the committee a comprehensive picture of agricultural trade option issues, I have submitted a written statement for the hearing record. That written testimony covers four main topics: (1) the statutory and regulatory history of agricultural trade options; (2) the history and current status of the Commission's agricultural trade options pilot program, including impediments to the program's usefulness; (3) possible amendments to the pilot program rules; and (4) the Commission's efforts to educate farmers about agricultural trade options. In my oral statement I will concentrate on the two issues highlighted in your letter inviting the Commission to testify here todayreviewing the progress of the Commission's agricultural trade options pilot program and analyzing alternatives for improving the program.
The progress report is simple. On June 16, 1998, after a long and difficult rulemaking process, interim final rules became effective establishing a CFTC pilot program for agricultural trade options. The rules permitted the offer and sale of off-exchange trade options in those basic agricultural commodities named in the Commodity Exchange Actincluding the grains, soybeans, cotton and livestocksubject to various regulatory requirements. The regulations included provisions for registration of Agricultural Trade Option Merchants (ATOMS), disclosure of risks to option buyers, financial safeguards, recordkeeping and reporting, and limitations on using the options for speculation. In the nearly 11 months since those pilot program rules took effect, no one has applied for registration as an Agricultural Trade Option Merchant. With no registered ATOMS to offer option contracts, no producers have been able to purchase options under the pilot program rules. In other words, the pilot program has not been utilized.
Page 86 PREV PAGE TOP OF DOC Segment 1 Of 4 The CFTC has worked hard to sort out the reasons for this situation and I know this committee shares our concern. As I see it, there are three reasons why the pilot program has not been used. The first is simple economics. The duration of the pilot program has coincided with a period of very low commodity prices and there is little incentive to use an option if the only result of doing so is to lock in a loss. Unfortunately, there is nothing the CFTC, as a price neutral regulator, can do about agricultural prices.
The second impediment to the pilot program's success is lack of information. In order to take advantage of the program, potential participants must have access to information about agricultural trade options in general, and about specific provisions of the pilot program as well. To that end, the Commission has undertaken various educational efforts, both on its own and in cooperation with USDA, aimed at educating farmers, potential ATOMS, lenders and extension agents about the pilot program. Those educational efforts are detailed in my written testimony.
The third impediment to the pilot program's successand I believe. the issue of most concern to this committeelies in the pilot program rules themselves. In structuring the pilot program, the Commission sought to strike a balancebetween the benefits of giving producers access to more and better risk management tools and the costs of potential fraud or misuse involving options and increased systemic risk. My own personal view is that the rules may have been overly influenced by the tenor of the times. Because the pilot program rules were drafted in the immediate aftermath of the hedge-to-arrive crisis, I believe a legitimate desire to avoid potential problems of a similar nature with agricultural trade options resulted in a program with a few too many regulatory bells and whistles.
In any event, the important issue today is not what led to problems with the pilot program, but what the Commission is doing to address those problems and revive the program. In that respect, I am happy to report substantial progress toward changes in the pilot program rules. I believe these changes hold the promise of making agricultural trade options a widely available and highly beneficial risk management tool for America's farmers.
Page 87 PREV PAGE TOP OF DOC Segment 1 Of 4 Since the rules were first issued, CFTC Commissioners and staff members have conducted numerous meetings with representatives of agricultural interests focusing on areas of concern in the pilot program rules. Agricultural trade options were also discussed at meetings of the Agricultural Advisory Committee on August 12, 1998 and again on April 21 of this year, when the committee heard presentations from representatives of the National Grain and Feed Association and the National Introducing Brokers Association and then engaged in a detailed discussion of potential rule amendments and the policy issues those alternatives would raise.
The areas where potential changes to the pilot program rules have been discussed include: (1) registration rules; (2) risk disclosure provisions; (3) physical delivery requirements versus cash settlement of options; (4) the ability of producers to write covered call options; (5) the appropriate net worth level to qualify for an exemption from the rules; and (6) revisions to further streamline the paperwork requirements
While we have not yet achieved a complete consensus on all these issues among all the interested parties, we have substantially narrowed the areas of disagreement. The dialogue has also been helpful in encouraging a number of producer organizations to develop a common approach to pilot program issues. Specifically, nine farm organizations, representing a broad cross-section of production agriculture, sent me a letter dated April 23 with a number of specific suggestions for rule changes to make the pilot program more user-friendly. I would like to submit a copy of this letter to be included in the hearing record. Those farm organizations have also been working with grain industry representatives to seek consensus in the remaining areas where they favor differing approaches to revising the pilot program.
While additional consensus among potential program participants is desirable, and the Commission intends to do all it can to help that process along, we do not plan to stand idly by in the meantime. Based on the extensive record already developed, I am pleased to announce that Commission staff will be preparing recommendations to the Commission for revising the pilot program rules. The remaining disputed areas can be addressed in the context of the rulemaking process. Bear in mind, those disputes are not fundamental. The farm organizations, the grain industry and the Commission all share a common goal. We all want the pilot program to succeed. I am confident that the remaining disagreements about the best way to achieve that success can and will be worked out as the rulemaking process goes forward.
Page 88 PREV PAGE TOP OF DOC Segment 1 Of 4 Mr. Chairman, your letter also asked whether legislative action might be necessary to address pilot program issues. I believe the encouragement we have already received from this committee has created an atmosphere conducive to compromise. In view of the interested parties' shared commitment to a successful pilot program, and the Commission's broad discretionary authority over options matters under existing law, I do not believe further legislative action by this committee will be needed. I believe we are already well on the road to a revitalized pilot program and I look forward to working closely with the committee as that journey continues. I am confident that we will reach our ultimate destination and that agricultural trade options will become a viable and valuable risk management tool for America's farmers.
THE HONORABLE DAVID D. SPEARS
Chairman, Agricultural Advisory Committee
Commodity Futures Trading Commission
1155 21st Street, N.W. Suite 9048
Washington, DC. 20581
DEAR COMMISSIONER SPEARS:
The undersigned farm organizations understand the Commission is considering a review of the Agricultural Trade Options pilot program. We are supportive of such an effort and urge that serious consideration be given to the following suggestions as a means to stimulate participation in the program, while ensuring an adequate level of regulatory oversight to maintain the program's integrity.
Page 89 PREV PAGE TOP OF DOC Segment 1 Of 4
1. Registration - A simplified registration system should be developed within the CFTC. Such a system should require a minimum level of financial safeguards and/or a bonding requirement to protect customers and reduce the likelihood that unscrupulous individuals will qualify as agricultural trade options merchants (ATOMS). In addition, a full range of dispute resolution options should remain available to contract participants ranging from arbitration under industry trade rules to CFTC reparations actions.
2. Reporting - The current pilot program operational rules concerning reporting, recordkeeping, risk disclosure and transactional confirmation are burdensome, expensive and provide limited security for parties to an ATO. We believe these rules could be substantially simplified while maintaining the ability of the CFTC to obtain the data necessary to fulfill its regulatory responsibilities and provide pilot program oversight. In addition, while customers should have access to their AT0 transaction , records and receive a written confirmation of any trade option contracts, the notification requirements of the pilot program could be significantly reduced.
3. Cash Settlement - In previous correspondence with the Commission, we outlined the need for a voluntary cash settlement provision for agricultural trade options. While we share the concern that cash settlement should not be used as a vehicle to speculate in this market, we continue to support some form of cash settlement opportunity to reflect the production and market realities of agriculture. We would be supportive of a limited cash settlement provision that restricted utilization to a one-time opportunity, or required other conditions prior to exercising that option.
3. Speculation - The rules established for the pilot program do not permit producers to sell covered calls presumptively due to the increased risk that could be undertaken. We remain uncertain as to the cost/benefit of such a arbitration for agricultural producers. Thus, until a convincing argument can be provided for waiving the existing rule, we support its continuation.
Page 90 PREV PAGE TOP OF DOC Segment 1 Of 4 5. Exemption Level - The current rules allow for an exemption from regulation for those parties to an AT0 that have a net worth of $10 million or greater. It has been suggested that the exemption level should be reduced to $1 million to be consistent with other off-exchange market exemptions. Providing an exemption from regulation will create a competitive inequity across the merchandising sector. In addition, an exemption would likely reduce the available data necessary for the Commission to review and provide oversight for the pilot program. We believe that if other regulatory modifications can be implemented to reduce the cost and simplify the process to encourage participation, an exemption at this time is unwarranted
Thank you for your consideration of these proposed modifications to improve the utility of the Agricultural Trade Options pilot program for producers. We look forward to working with you and your colleagues at the CFTC as you review the current regulatory structure.
AMERICAN FARM BUREAU FEDERATION, AMERICAN SOYBEAN ASSOCIATION, NATIONAL ASSOCIATION OF WHEAT GROWERS, NATIONAL CATTLEMEN'S BEEF ASSOCIATION, NATIONAL CORN GROWERS ASSOCIATION, NATIONAL COTTON COUNCIL OF AMERICA, NATIONAL FARMERS UNION, NATIONAL GRAIN SORGHUM PRODUCERS, NATIONAL PORK PRODUCERS
U.S. COMMODITY FUTURES TRADING COMMISSION
Washington, DC, June 17,1999
THE HONORABLE DOUG OSE
U.S. House of Representatives
Page 91 PREV PAGE TOP OF DOC Segment 1 Of 4 Washington, DC 20515
DEAR REPRESENTATIVE OSE,
I am writing in response to the questions you submitted for the record of the May 18, 1999, hearing on reauthorization of the Commodity Futures Trading Commission before the United States House of Representatives, Committee on Agriculture, Subcommittee on Risk Management, Research and Specialty Crops. Your questions relate to the Commission's pilot program for Agricultural Trade Options (ATO), including the requirement that the option include an exercise
date, whether they are insured, and the nature of their price transparency as well as the Commission's ability to stay abreast of market developments.
At the outset, let me assure you of my commitment to a viable and useful AT0 program. As I noted in my May 18 testimony, I recognize that there are problems with the existing AT0 pilot program, and Commission staff is already at work drafting amendments to make the pilot program more user-friendly. To provide you with a comprehensive overview of the history, status, and problem areas involving the AT0 pilot program, I have enclosed copies of written and oral testimony regarding the program from my May 5, 1999, appearance before the Senate Agriculture Committee. The remainder of this letter consists of information compiled by the Commission staff in response to your May 18 questions, including information on the existing AT0 program.
I. The pilot program for agricultural trade options permitted the reintroduction of the offer and sale of over-the-counter commodity options on certain agricultural products. These types of option contracts had been prohibited by statute or rules for over 60 years. Trade option contracts function similarly to exchange-traded options except that they are negotiated and entered into as bilateral contracts off of a designated contract market and must involve commercial counterparties. An option contract gives the purchaser of the contract the right, but not the obligation, to buy or sell a specified amount of commodity for a specified price on or before a specified exercise or expiration date.
Page 92 PREV PAGE TOP OF DOC Segment 1 Of 4 The option expiration date gives certainty to the contracting parties as to when the contract ends. The pilot program's rules require that the option contract be written and include such information as the expiration date along with other terms to avoid one of the problems observed by the Commission in a large number of instances involving hedge-to-arrive contracts. In those instances, vital contractual terms were not included in the written contract, creating legal problems regarding the enforceability of the contract and giving rise to the issue of appropriate disclosure of the exact terms and nature of the agreement. By specifying that options under the pilot program provide for certain written terms, including the expiration date, the rules prevent a repeat of this serious problem.
II. Performance on agricultural trade options is not guaranteed or insured. In certain states, producers 'grain that has been delivered to an elevator is insured through a state insurance fund or through a bond purchased by the elevator. This insurance or bonding protection, however, typically covers only grain that has been delivered to an elevator and not the value of an outstanding forward contract or other similar commitment. Similarly, an agricultural trade option generally would not be insured or guaranteed under the common state insurance or bonding programs. However, producers 'interests in grain once delivered under an agricultural trade option would likely be subject to similar protections as grain delivered under any other type of contract.
In addition to whatever protection is afforded a producer under standard state insurance or bonding programs, the agricultural trade option program contains several regulations designed to protect producers 'financial interests. The interim final rules require that in order to register as an agricultural trade option merchant, the registrant must maintain a minimum net worth of $50,000. This requirement was included to provide limited protection against default by the elevator. The rules also contain a requirement that agricultural trade option merchants hold in segregation all premiums paid by customers at the initiation of an option contract. The segregation requirement discourages financially troubled vendors from writing options to generate immediate cash and thereby safeguards customer funds. The only exception to this requirement is to permit the agricultural trade option merchant to use customer funds to purchase exchange-traded instruments to cover the agricultural trade option. This provides an additional means of offering the customer indirect protection against the elevator's inability to perform on the contract.
Page 93 PREV PAGE TOP OF DOC Segment 1 Of 4 III. You also asked about price transparency, especially at the local level. The rules of the AT0 pilot program include several measures to ensure that producers have access to information regarding their option positions and prices. Under the rules of the program, agricultural trade option merchants are required to provide customers ''[within 24 hours of a request by the customer, or 48 hours of a request for response in writing, current commodity price quotes, all other information relevant to the customer's position or account, and the amount of any funds owed by, or to, the customer.'' Such information is intended to aid customers in monitoring the status of their account or position and in making informed decisions regarding the exercise of their options. In addition to valuable option contracts may be about to expire. Finally, where trade option contracts are written on commodities having exchange-traded counterparts, the prices reported for the exchange-traded contracts will serve as a good indication of general price levels for the trade options.
A separate issue, although related to the issue of price information, is the issue of generalized information or knowledge of risk shifting instruments and strategies by producers. In general, the use of exchange-traded risk shifting instruments (futures and option contracts)among producers is low. Producers are more likely to use forward sales contracts to reduce their risk of falling prices. The removal of the prohibition on certain agricultural trade options potentially will give producers another tool for shifting price risks on the crops and livestock they grow. To assist producers in using these tools, the Commission has produced three educational pamphlets describing the AT0 pilot program and how agricultural trade options may fit into their risk management programs. In addition, the Commission continues to work closely with the Risk Management Agency and supports private sector initiatives to educate producers on risk management.
IV. Generally, the CFTC has demonstrated a great deal of flexibility and capacity to deal with innovations in the financial markets for risk management products and anticipates being able to continue to be responsive in the future. The AT0 pilot program was introduced as a three-year program in order to give the Commission the opportunity to evaluate the reintroduction of agricultural trade options. The Commission has considered the issues surrounding the prohibition on agricultural trade options several times over the past 20 years. In 1997, the Commission reviewed the issues surrounding the AT0 prohibition and produced a policy alternative paper on the issue. Based on extensive discussions with, and input from, the public the Commission approved the three-year pilot program. In approving the program, the Commission stated its intention to monitor the program on an ongoing basis; and, although the rules as promulgated are interim final rules, the Commission has expressed its intent to modify them as necessary.
Page 94 PREV PAGE TOP OF DOC Segment 1 Of 4 In response to your concerns about Long-Term Capital Management's (LTCM), due to large trade reporting requirements, both the CFTC and the U.S. futures exchanges had full and accurate information about LTCM's reportable on-exchange futures position, and LTCM had no reportable positions in agriculture futures contracts. In fact, LTCM was prompt and fully paid all margin obligations on its funds' futures positions on U.S. exchanges. The serious financial difficulty of LTCM was mostly due to large highly-leveraged positions, exposures, and investment strategies in the OTC derivatives market that has no routine reporting requirements.
David D. Spears, Acting Chairman
Testimony of James E. Newsome
Thank you Mr. Chairman and members of this distinguished subcommittee. I am pleased to be here to testify before you today, and I thank you for the opportunity to discuss issues relating to reauthorization of the Commodity Futures Trading Commission. I applaud your efforts to gather information and data regarding modernization of the Commodity Exchange Act, as I believe that this reauthorization period provides a unique opportunity for Congress to make necessary changes to the act that will benefit the industry and market participants, as well as provide clearer guidelines for appropriate regulation by the Commission.
There are several topics that I will offer today for your review, but I would like to begin by stressing two overarching principles that I believe are critical in this analysis: providing legal certainty and decreasing regulatory burdens should be the key elements in any review and amendment of the act. In order to accomplish this, we need to listen to industry participants regarding the effects of regulation on the day-to-day matters of financial and agricultural risk management and price discovery, and respond accordingly. We as public servants are charged with protecting the interests of the public, and we cannot do justice to that obligation unless and until we listen carefully to those most directly affected by our actions. I also feel that, as responsible regulators, the Commission must be responsive to not only industry, but also to the Congress as we work through reauthorization. We must cooperate with members of this committee to develop a regulatory scheme that discourages fraud and manipulation, but encourages innovation, technology, fair competition, and sound business practices.
Page 95 PREV PAGE TOP OF DOC Segment 1 Of 4 In addition, I believe there is a significant corollary issue to the goal of decreasing regulatory burdens that should be considered. It goes without saying that businesses will seek to operate in the most efficient fashion; accordingly, if the opportunity presents itself to avoid regulatory costs by operating outside the borders of the United States, many businesses will make the logical decision to take advantage of that opportunity. Therefore, I believe it is critically important to engage in sensible cost/benefit analyses in making regulatory decisions, as some of those determinations be of limited utility, and may simply move businesses and dollars out of our economy. (Indeed, I believe in some cases that has already occurred.) Not only that, overly burdensome regulation has the effect of moving those entities outside the sphere of our policy-making authority. In other words, with the exodus of business beyond our borders goes the ability of the United States to continue to make policy determinations that affect the global economy. I do not want to overstate the matter, however, given current technological advancements, I firmly believe that we as law makers and enforcers must be acutely sensitive to this issue in order to maintain the primacy of our markets as world-wide leaders and innovators.
I join with you in the desire to identify areas I believe have suffered from regulatory overreaching, confusion, or misunderstanding; and, indeed, I have already begun the process of taking steps to initiate changes that can be made under our current regulatory authority to decrease regulatory burdens and promote legal certainty. In that vein, I recently convened a meeting with representatives from the three largest futures exchanges in the United States. I asked them to come to this meeting ready to discuss concrete, practical initiatives that we can undertake promptly to address their regulatory concerns. I was extremely gratified with the outcome of that meeting, and have accumulated a significant list of projects that I believe the CFTC can and should act on in an expeditious manner. Furthermore, I plan to continue to exhort staff and industry to work together to review these issues to determine in what areas we can make significant inroads in decreasing unnecessary regulatory burdens.
Page 96 PREV PAGE TOP OF DOC Segment 1 Of 4 Along those lines, let me say I believe that regulatory reform should be industry-driven. It is clear to me that market discipline and adherence to best-practice standards can achieve better enforcement of fundamental market integrity concerns than can any amount of overlaid regulation. Accordingly, I advocate stripping away unnecessary, costly regulation, and at the same time maintaining the ability to ensure forceful, swift prosecution and significant punishment for those outliers who commit core violations of the act. I believe that more reliance on private sector discipline and better use of public regulation fosters these interests and I look forward to hearing from market participants and users to tell us how they envision achieving these goals. I am glad to see that this subcommittee will hear from them this week as well.
With regard to modernization of the CEA, there are several areas of regulatory reform that under current authority cannot be addressed at the agency levelissues that require Congressional review, analysis and disposition. I would like to focus the remainder of my remarks on highlighting general themes and specific topics for your examination. Let me reiterate that, in my opinion, the end result of such review should be regulation that fosters efficient and liquid markets, enhances the ability of market participants to innovate and compete effectively, and does not create artificial and costly barriers to trade and competition. Ultimately, I believe the CFTC should concentrate on what Congress intended us to do when it created the Commission in 1974, that is, protect participants against fraud and manipulation and ensure safe, sound, and competitive markets.
ELECTRONIC TRADING ISSUES
During the past year, I have been struck by the number of issues that in some way involve electronic trading; it is clear that we are witnessing a sea change in the way markets work. For example, who would have thought 10 years ago that we would be considering trading over the Internet? Who knows what technological advancements in futures and options trading will be presented to us in 10 more years? I believe it is critically important that the CFTC have the flexibility to be innovative from a regulatory standpoint regarding those within industry who are creative and visionary, and we must work with the Congress in determining how much flexibility the Commission needs to address the changing technological environment. Given this regulatory agility, the Commission can encourage, and not impede, those who think outside of the traditional box.
Page 97 PREV PAGE TOP OF DOC Segment 1 Of 4 As I have stated before, I believe the intense interest in this topic is fueled by two issues: first, the rapidly increasing globalization of the futures and options markets in particular and financial markets in general; and secondly, the tremendous advances in electronic trading technologies and activity. The lower transaction costs and the inherent benefits regarding oversight of electronic trading systems make them an attractive complement or alternative to traditional trading methods. However, at the time of the promulgation of the act and regulations, it obviously was not possible to contemplate such incredible changes in the way markets today effect transactions and conduct business. Accordingly, I think Congress needs to take a comprehensive look at the act with an eye toward making amendments to accommodate these changes relating to electronic trading. I would submit, for example, that provisions relating to designation of a completely electronic exchange should be reviewed. Also, as the movement to electronic trading systems may have an effect on the design of exchange governance systems, let me say that the current law envisions designation of traditional membership exchanges, as opposed to proprietary exchanges, and I believe these issues also deserve Congressional attention.
ISSUES RELATING TO LEGAL CERTAINTY
In May 1998, the Commission issued a concept release relating to over-the-counter derivatives. The issuance of that document created significant legal uncertainty in a dynamic and vital market. Ultimately, this resulted in Congressional action instituting a moratorium on Commission action until Congress has the opportunity to address the issue. That opportunity is now before you. I remain committed to the principles I have stated time and again during my tenure at the CFTC: market participants must have clear and unambiguous understanding of the nature of their regulatory responsibilities. I recognize that there are several different avenues that have been suggested to you in this area. For example, some exchanges have proposed making a distinction between privately- and publicly-negotiated instruments, and regulating accordingly. You have also heard of proposals relating to allowing market participants to choose their regulator. You have heard discussions of institutional, as opposed to functional regulation. Once again, let me say that I do not have answer for you as to how you should make your final judgments: the various sectors of the industry must make clear to you what their concerns and desires are in order for you to best make your determinations in this area. I look forward to continuing discussions with market participants and with other regulators to review the numerous aspects and ramifications of regulatory options on this topic, and I would offer that we should keep in mind during this debate the primary public policy aims I have mentioned.
Page 98 PREV PAGE TOP OF DOC Segment 1 Of 4 Let me also mention that legal uncertainty has not been confined to the issue of OTC instruments. We have also heard many comments regarding this problem as it relates to other issues, for example, the definition of a forward contract. As I am made aware of these issues by market participants, I hope that they will also convey their concerns to you.
There has been discussion of specifically reducing the regulatory authority of the CFTC, and/or merging the CFTC and the SEC. I want to state that I believe the agricultural emphasis should be maintained in a clearly defined way, given the role commodity markets play as significant risk management and price-discovery tools for American agriculture. In whatever manner this issue is ultimately addressed, the CFTC should have the statutory flexibility to allow markets to grow and prosper, and to continue to be useful mechanisms for agribusiness concerns.
I believe that the Commodity Futures Trading Commission has an extremely talented and dedicated group of people, committed to public service, and I am proud to be associated with them. However, the fact of the matter is that times have changed, we must change with them, and I am confident that we have professional, responsible staff to carry out the mandates issued by this Congress. Let me reiterate my belief that providing legal certainty and decreasing overly burdensome regulation should be paramount concerns as you proceed in this task, and I am committed to working with you, your staffs, other regulators, and industry participants as we take advantage of this unique opportunity to modernize the Commodity Exchange Act. I recognize that this will not be an easy or quick undertaking, and that it will require compromise on the part of all interested parties to reach an appropriate consensus. However, as noted in the recent GAO report on the CFTC's reauthorization, the cost of not reaching consensus in this area is high, and I encourage the industry to continue their efforts to make their viewpoints known to Congress and to regulators. Thank you, and I would be happy to answer any questions you may have.
Page 99 PREV PAGE TOP OF DOC Segment 1 Of 4
Testimony of Barbara P. Holum
Mr. Chairman and members of the subcommittee, thank you for the opportunity to testify concerning reauthorization of the CFTC. The views I am expressing are my own and are not the views of the Commission. I wish to commend the subcommittee for recognizing that reauthorization of the CFTC raises important policy questions concerning both U.S. and global financial markets.
While the three main purposes of the Commodity Exchange Act: (1) financial security, (2) market integrity, and (3) customer protection remain valid, evolutionary change in the marketplace demands new approaches in achieving these objectives.
I view this reauthorization process as an important and positive opportunity to eliminate a regulatory posture which simply does not fit current financial markets and institutions. We should not continue to try to make our dynamic and innovative markets conform to outmoded regulatory programs. Instead, we as regulators of the most creative and successful markets in the world should be looking ahead and working closely with industry participants to craft regulatory oversight which works.
A better approach would develop guidelines or principles granting regulated entities needed flexibility in meeting common regulatory objectives. This approach, incorporating business or conduct codes, could improve the effectiveness of regulation and at the same time reduce regulatory costs.
I would like to briefly review for you three recent examples of why we must move quickly away from the rigid, prescriptive micro-management approach to regulation.
The CFTC's unilateral effort to initiate expanded regulation of the over-the-counter derivatives market failed to achieve acceptance among those with either a business or regulatory interest. The concept release on OTC regulation, which included more than 70 questions about the best approach to regulate that market, succeeded only in increasing legal uncertainty. As a corrective measure, we must adopt an open and cooperative attitude toward working with our fellow regulators, the SEC, the Treasury, the Federal Reserve Board, and the Congress, as was not done with OTC derivatives.
Page 100 PREV PAGE TOP OF DOC Segment 1 Of 4 Similarly, a burdensome approach in regulating agricultural trade options failed to expand risk management tools available to agricultural producers and consumers. Although the CFTC received overwhelming comment from agricultural interests cautioning against the implementation of detailed prescriptive rules, the CFTC nonetheless promulgated extensive and costly regulatory mandates. The result to date is that not one person has registered as an agricultural trade option merchant. We must listen when market participants advise us on the design of risk management programs, as was not done with the agricultural trade options program.
Current debate surrounding the CFTC's proposed rules on access to foreign terminals again shows that a rigid or formulaic approach to regulation is inapplicable in the modern business environment. As part of this initiative, there has been a moratorium on any action to permit the placement of foreign terminals in the U.S. since late 1997, which has imposed an unfair burden on competition and denied end-users in the U.S. the benefits of access to foreign markets. The CFTC should never again propose rules and regulations prior to adequate consultation with the industry and with all CFTC commissioners.
As you may know, I am chairman of the CFTC's Global Markets Advisory Committee. The purpose of GMAC is to advise the Commission on issues concerning the competitiveness of U.S. markets and U.S. firms engaged in global business. Recognizing the critical importance of addressing the competitive regulatory issues facing U.S. exchanges, I have formed a steering committee within GMAC. That committee has agreed to identify and recommend solutions to address the regulatory parity issues surrounding automated access to foreign exchanges. I believe that we must recognize and respond promptly to the very real concerns regarding the regulatory burdens impacting the competitiveness of U.S. exchanges. Our domestic exchanges have been and should remain at the forefront of this industry and should not be impeded by unnecessary, burdensome, and archaic regulations. At the same time, we must ensure that our markets remain the safest and soundest in the world.
Page 101 PREV PAGE TOP OF DOC Segment 1 Of 4 We cannot stop the technological advances that are rapidly redefining the way the industry does business. Instead, we must recognize the extraordinary benefits of these vast new technologies. New technology benefits us as regulators by providing new tools that enhance our market and trade practice surveillance capabilities. Likewise, the exchanges must be permitted to maximize the benefits of new technology on their trading floors and in their surveillance departments. To do so, they must not be subject to the same set of requirements designed for a different era of trading.
As we chart a course to take us into the next millennium, we should not attempt to micro-manage our markets through an outmoded regulatory program. To assume that the CFTC should adopt regulations to control all risk contingencies, no matter how remote, for every new technological advancement would constitute poor public policy. Such an approach risks regulatory gridlock that stifles innovation, impedes productivity growth, and harms U.S. competitiveness.
In conclusion, as we work together over the next several months on this reauthorization process I hope our end product will reflect the following three elements: cooperation, flexibility, and democracy. We are a free society overseeing a free market adopting rules and regulations in concert with, not in spite of, all other regulators and market participants.
Thank you. I would be pleased to answer any questions members of the subcommittee may have.
U.S. COMMODITY FUTURES TRADING COMMISSION
June 25, 1999
THE HONORABLE DOUG OSE
U.S. House of Representatives
Washington, DC 20515
Re: Questions Submitted for the Record of the May 18, 1999, Hearing on Reauthorization of the Commodity Futures Trading Commission before the United States House of Representatives, Committee on Agriculture, Subcommittee on Risk Management, Research and Specialty Crops.
Page 102 PREV PAGE TOP OF DOC Segment 1 Of 4 DEAR REPRESENTATIVE OSE:
I am pleased to respond to the above-referenced questions you submitted for the record. Your questions relate to the Commission's pilot program for agricultural trade options (ATO), and focus on provisions concerning exercise, insurance, and price transparency.
While I generally have supported expansion of risk management programs for agriculture, I had serious reservations about the AT0 program as adopted. Indeed, since its adoption, I have encouraged the Commission to undertake a remedial review of the AT0 program and have questioned whether the Commission should publish AT0 pamphlets without revisiting the terms of the pilot program (see attached remarks). In this regard, and as indicated in Acting Chairman Spears' letter on this subject, staff is now working to draft amendments to make the pilot program more user friendly. Thus, I remain hopeful that the AT0 program can be amended to eliminate those provisions that prevent a valid market test.
Staff have compiled information that specifically responds to the questions included in your request. As acknowledged by Commissioner Spears' letter, that analysis served to inform the answers included in his letter. I generally agree with the staff's analysis and also have used that information as a foundation in forming responses to your questions. I would of course be pleased to respond to any follow-up requests you may have for additional information on the AT0 pilot program or on any other Commission regulatory program.
1. Because of large trade reporting requirements, both the CFTC and U.S. futures exchanges had full and accurate information about Long-Term Capital Management's (LTCM) reportable on-exchange futures position, and LTCM had no reportable positions in agricultural futures contracts. In fact, LTCM was prompt and fully paid all margin obligations on its funds' futures positions on U.S. exchanges. The serious financial difficulty of LTCM was mostly due to large highly leveraged positions, exposures, and investment strategies in the OTC derivatives market that has no routine reporting requirement.
Page 103 PREV PAGE TOP OF DOC Segment 1 Of 4 2. A. Performance on agricultural trade options is not guaranteed or insured. In certain states, producers' grain that has been delivered to an elevator is insured through a state insurance fund or through a bond purchased by the elevator. This insurance or bonding protection, however, typically covers only grain that has been delivered to an elevator and not the value of an outstanding forward contract or other similar commitment. Similarly, an agricultural trade option generally would not be insured or guaranteed under the common state insurance or bonding programs. However, producers' interests in grain once delivered under an agricultural trade option would likely be subject to similar protections, as grain delivered under any other type of contract.
In addition to whatever protection is afforded a producer under standard state insurance or bonding programs, the agricultural trade option program contains several regulations designed to protect producers' financial interests. The interim final rules require that, in order to register as an agricultural trade option merchant, the registrant must maintain a minimum net worth of $50,000. This requirement was included to provide limited protection against default by the elevator. The rules also contain a requirement that agricultural trade option merchants hold in segregation all premiums paid by customers at the initiation of an option contract. The segregation requirement discourages financially troubled vendors from writing options to generate immediate cash and thereby safeguards customer funds. The only exception to this requirement is to permit the agricultural trade option merchant to use customer funds to purchase exchange-traded instruments to cover the agricultural trade option. This provides an additional means of offering the customer indirect protection against the elevator's inability to perform on the contract.
2-B. The expiration date for agricultural trade options gives certainty to the contracting parties as to when the contract ends. The pilot program's rules require that the option contract be written and include such information as the expiration date along with other terms to avoid potential problems associated with contractual ambiguities. By specifying that options under the pilot program provide for certain written terms, including the expiration date, the rules avoid undue risk of confusion over the exact terms and nature of the agreement and any associated problems relating to enforceability.
Page 104 PREV PAGE TOP OF DOC Segment 1 Of 4 3. With respect to price transparency, the rules of the ATO pilot program include several measures to ensure that producers have access to information regarding their option positions and prices. Under the rules of the program, agricultural trade option merchants are required to provide customers ''[within 24 hours of a request by the customer, or 48 hours of a request for response in writing, current commodity
price quotes, all other information relevant to the customer's position or account, and the amount of any funds owed by; or to, the customer.'' Such information is intended to aid customers in monitoring the status of their account or position and in making informed decisions regarding the exercise of their options. In addition to requiring prompt responses to customers' inquiries, agricultural trade option merchants are currently required to notify customers in writing of any option contracts that will expire within the subsequent calendar month. This notification is intended as a ''heads up 11 to alert producers that potentially valuable option contracts may be about to expire. Finally, where trade option contracts are written on commodities having exchange-traded counterparts, the prices reported for the exchange-traded contracts will serve as a good indication of general price levels for the trade options.
A separate issue, although related to the issue of price information, is the issue of generalized information or knowledge of risk shifting instruments and strategies by producers. In general, the use of exchange-traded risk shifting instruments (futures and option contracts)among producers is low. Producers are more likely to use forward sales contracts to reduce their risk of falling prices. The removal of the prohibition on certain agricultural trade options potentially will give producers another tool for shifting price risks on their crops and livestock. The Commission also continues to work closely with the Risk Management Agency and supports private sector
initiatives to educate producers on risk management.
4. Generally, the CFTC has demonstrated a great deal of flexibility and capacity to deal with innovations in the financial markets for risk management products and anticipates being able to continue to be responsive in the future. The AT0 pilot program was introduced as a 3-year program in order to give the Commission the opportunity to evaluate the reintroduction of agricultural trade options. The Commission. has considered the issues surrounding the prohibition on agricultural trade options several times over the past 20 years. In 1997, the Commission produced a policy alternative paper on the issue, and in 1998 the Commission approved the 3-year pilot program. Although the AT0 rules were adopted as interim final rules, the Commission continues to monitor the program on an ongoing basis, and has expressed its intent to modify the rules as necessary.
Page 105 PREV PAGE TOP OF DOC Segment 1 Of 4 Sincerely yours,
BARBARA PEDERSEN HOLUM
CONCURRING REMARKS OF COMMISSIONER BARBARA PEDERSEN HOLUM INTERIM FINAL RULES
TRADE OPTIONS ON THE ENUMERATED AGRICULTURAL COMMODITIES
I agree with and join in the action the Commission is taking to permit exchange trading .of options on physicals on the enumerated agricultural commodities. In particular, I believe this important initiative recognizes the potential of exchanges in offering more flexible option contracts. Exchanges in the past have demonstrated an exceptional ability to meet the demands of the market. I am therefore confident, now that the prohibition is to be lifted, the exchanges will work with the end-users to develop option contracts with the necessary flexibility to meet their individualized needs.
While I also join in the Commission's lifting of the prohibition on the offer and sale of off-exchange trade options on the enumerated agricultural commodities, I have serious concerns about the extensive regulatory provisions included in the interim rules. Specifically, these interim rules create a regulatory infrastructure essentially duplicating that which already exists on the exchangesWhile the Commission has acted to exempt other off-exchange transactions from much of the centralized regulatory structure, these interim rules impose new, extensive, and costly regulatory mandates. In my opinion, the imposition of this far-reaching regulatory structure, and its additional costs, will limit participation and deny producers and processors the very risk management tools that lifting the ban envisions.
DISSENTING REMARKS OF COMMISSIONER BARBARA PEDERSEN HOLUM AGRICULTURAL TRADE OPTION INFORMATIONAL PAMPHLET
Page 106 PREV PAGE TOP OF DOC Segment 1 Of 4 When the Agricultural Trade Options Program was adopted last April, there was an astonishing degree of comment opposing many of the regulatory provisions of the Program. When the Commission adopted the Program, I opposed these new regulatory mandates on grounds that they were too costly and burdensome, and would deter successful introduction of the Program. Our experience with the Program during the eight months since its adoption bears. this out, with little or no evidence of Program viability. In fact, the Division of Economic Analysis has reported that not even one single person has applied for registration as an Agricultural Trade Options Merchant (ATOM).
More recently, a National Grain and Feed Association (NGFA) letter cautioned the Commission not to misinterpret the lack of ATOM sign-up as an absence of interest in ''more and better risk management services.'' NGFA instead maintains that the CFTC should consider how the Program ''could be modified to achieve a valid market test.''
For these reasons, rather than expending scarce resources on issuance of the proposed pamphlet, I believe the Commission should suspend work on this and the two additional pamphlets under preparation, and undertake a remedial review of the Program's terms. The experience of the past eight months confirms that the Program was ill-designed and should be revised to meet market requirements. To accomplish this, we should not attempt to force a failed Program on the agricultural. sector, but instead heed their comments concerning these programmatic needs. At this point, I believe the Division of Economic Analysis should undertake a market review, including trade interviews of market participants and the previous commenters. The Division then should report to the Commission with recommendations on how the Program can be revised to provide a workable plan.
For the reasons outlined above, I am dissenting from the adoption of the proposed pamphlet.
Page 107 PREV PAGE TOP OF DOC Segment 1 Of 4 DISSENTING REMARKS OF COMMISSIONER BARBARA PEDERSEN HOLUM AGRICULTURAL TRADE OPTION INFORMATIONAL PAMPHLETS NOS. 2 AND 3
Prior to adoption of the Agricultural Trade Options Program, the Commission received a remarkable amount of comment opposing many of the regulatory provisions of the Program. When adopted in April 1998, I opposed the Program's regulatory structure on grounds that it was too costly and burdensome, and would deter successful introduction of the Program.
In December 1998, the Commission published the first of a series of pamphlets describing the Program, and the Commission is now proposing to publish two additional pamphlets. I opposed publication of the first pamphlet, and I respectfully dissent from publication of these two additional pamphlets as well.
Rather than expending scarce resources on publication of Program pamphlets, I believe the Commission should instead undertake a remedial review of the Program's terms. After passage of nearly a year, there is little evidence of Program viability. In fact, no one has applied for registration as an Agricultural Trade Options Merchant, confirming that revisions are needed to meet market requirements. In short, I believe it is inappropriate for the Commission to publish these pamphlets promoting the Program after it has received a vote of ''noconfidence'' in the marketplace.
For the reasons outlined above, I dissent from the adoption of the two pamphlets.
Testimony of Annette L. Nazareth
Chairman Ewing and members of the subcommittee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission concerning the reauthorization of the Commodity Futures Trading Commission and related issues that affect the SEC.
Since the CFTC began operating in 1975, Congress has used the reauthorization process as an opportunity to comprehensively review the Commodity Exchange Act and examine the role of the CFTC. We work closely and cooperatively with the CFTC on an ongoing basis, and support its rapid reauthorization. Although we have commented on many issues involving the oversight of derivatives and remain vitally interested in these issues, I will focus today on two subjects.
Page 108 PREV PAGE TOP OF DOC Segment 1 Of 4 I. PRESERVATION OF THE SHAD-JOHNSON JURISDICTIONAL ACCORD
One item that will likely receive attention during the current reauthorization process is the Shad-Johnson Jurisdictional Accord between the SEC and the CFTC. the accord, which Congress codified in 1982, bans single stock futures and futures on narrow-based stock indexes. It also permits, under the CFTC's supervision, trading of broad-based stock index futures that meet certain criteria, subject to the Commodity Exchange Act.
The accord was designed to address uncertainties concerning the regulation of certain securities-based derivative products that stemmed from changes made to the commodity futures laws in 1974. Those changes gave the CFTC exclusive jurisdiction over all futures, whether the underlying commodity was a traditional commodity like pork bellies or a financial commodity like an interest rate.
At the same time though, Congress provided that the jurisdiction of the SEC would not otherwise be limited or superseded. As a result, it was unclear whether the CFTC or the SEC had jurisdiction over futures on securities, a group of securities, or an index based on securities. This uncertainty, exacerbated by the ''Ginnie Mae'' options dispute, In 1975, the CFTC approved a Chicago Board of Trade proposal to offer futures contracts on Government National Mortgage Association (*GNMA* or *Ginnie Mae*) pass-through securities. The SEC asserted that the GNMA futures were securities within its jurisdiction, while the CFTC contended that the futures fell within their exclusive jurisdiction. The SEC later approved a Chicago Board Options Exchange proposal to trade GNMA options in 1981. The Chicago Board of Trade sued the SEC over that approval, and in the Ginnie Mae options case, the 7th Circuit Court of Appeals set aside the SEC*s order approving the GNMA options, stating that GNMA options were not *securities* within the meaning of the Securities Exchange Act and that the SEC had no authority to regulate them. See Board of Trade of City of Chicago v. S.E.C., 677 F.2d 1137 (7th Cir. 1982), vacated as moot, 459 U.S. 1026 (1982).
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created conflicts regarding each agency's jurisdiction over novel financial instruments that had elements of securities and futures products.
To resolve the jurisdictional issues, the SEC and the CFTC agreed to clarify which financial instruments fell within each agency's jurisdiction. Under the terms of the accord, the SEC would regulate options on: securities (including exempted securities), certificates of deposit, foreign currencies traded on a national securities exchange, and stock groups or indexes.
The CFTC would regulate futures and options on futures on: exempted securities (except municipals), certificates of deposit, and ''broad-based'' indexes of securities. The CFTC also would oversee options on foreign currencies that are traded on a board of trade and not traded on a national securities exchange. See Joint Explanatory Statement of SEC and CFTC, [1980-1982 Transfer Binder] Comm. Fut. L. Rep. (CCH) 21,332 (Feb. 2, 1982).
The SEC and the CFTC agreed that futures on individual securities (including equities, corporate bonds, and municipal securities) would be prohibited.
In the 17 years since the accord became effective, the SEC and CFTC have cooperated together to facilitate the introduction of innovative new futures products. Under the terms of the accord, the SEC must review all proposed securities index futures contracts and determine whether they comply with the accord's requirements. Among the securities index futures contracts reviewed by the SEC and approved by the CFTC for trading are industry sector stock indexes, See, e.g., Letter from Robert L.D. Colby, Deputy Director, Division of Market Regulation, SEC, to Steven Manaster, Director, Division of Economic Analysis, CFTC, dated March 12, 1999 (not objecting to the designation of the Kansas City Board of Trade as a contract market for futures and options on futures on the Internet Stock Price Index).
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bond indexes, See, e.g., Letter from Jonathan G. Katz, Secretary, SEC, to Dr. Paula Tosini, Director, Division of Economic Analysis, CFTC, dated August 24, 1987 (not objecting to the designation of the Chicago Board of Trade as a contract market for futures on the Long-Term Corporate Bond Index).
and foreign stock indexes. See, e.g., Letter from Shirley E. Hollis, Assistant Secretary, SEC, to Dr. Paula Tosini, Director, Division of Economic Analysis, CFTC, dated October 11, 1988 (not objecting to the designation of the Chicago Mercantile Exchange as a contract market for futures on the Europe, Australia, Far East Index).
The futures exchanges now advocate repealing the accord. This would lift the current ban on single stock and narrow-based stock index futures, permitting them to introduce a whole new series of securities-based products.
While the Commission is sensitive to the futures markets' desire to expand the base of available futures products, the full consequences of repealing the accord should not be oversimplified. There are some very complex issues that would need to be carefully addressed before the accord is reconsidered by Congress.
The delicate balance achieved by the accord should not be disrupted absent the type of consultation and cooperation displayed by the SEC, CFTC, and their oversight committees in reaching the accord in 1982. The repeal of the accord would have significant consequences, not only for the SEC and CFTC, but also for the market participants subject to their oversight. Radical changes to the regulatory landscape should not be undertaken lightly; instead, the effect of any proposed changes should be subject to the scrutiny and careful review of Congress and both agencies.
Page 111 PREV PAGE TOP OF DOC Segment 1 Of 4 This review must take into account the major disparities between securities and futures regulation. The SEC believes that repealing the accord in the face of these disparities will work to the detriment of our capital markets and investors in those markets. For this reason, the SEC is opposed to the repeal of the accord and the trading of single stock and narrow-based index futures at this time. We believe the integrity of our securities markets would be jeopardized if disparities between securities and futures regulation were used to undermine the securities law provisions that serve to maintain fair and orderly markets for stocks and bonds. The Commission is particularly concerned that if futures on single stocks and narrow-based indexes are traded under the existing futures regulatory regime, buyers and sellers of such futures would not be afforded the same protections that are provided to buyers and sellers of stocks and stock options under the Federal securities laws. For example, margin requirements are significantly lower, broad statutory prohibitions against insider trading do not apply, implied private rights of action for fraud are unavailable, and customer suitability determinations are not mandatory under existing futures regulation.
The disparity in margin requirements alone could result in a shift of equities-based activity to the futures markets, entirely outside the scope of the securities laws and their important protections. As a result, it is possible that the cash markets could become less relevant, perhaps even serving only as the market for those seeking physical settlement. Under the futures exchanges* proposal, all futures on non-exempt securities would be required to be cash-settled.
This could have significant adverse consequences for issuers and others that access our securities markets to satisfy capital needs.
Moreover, purchasers of single stock futures would be at risk of significant losses if they do not fully understand the concept of leverage and the magnification of price movements inherent in the futures markets. Retail investors recently have suffered sizable losses in volatile sectors of the equity and options markets, even though the leverage in those markets is considerably less than that which would be available to users of single stock futures.
Page 112 PREV PAGE TOP OF DOC Segment 1 Of 4 The disparate treatment of insider trading in the futures arena is another area that raises serious concerns. In contrast to the broad prohibitions against insider trading found in the securities laws, the CFTC's regulations contain a narrow provision that prohibits only a small class of futures industry insiders from trading on non-public material information.CFTC Regulation 1.59, which was adopted to implement the insider trading provisions found in Section 9(f) of the Commodity Exchange Act (*CEA*), requires that each futures SRO (i.e., futures exchanges, National Futures Association, and clearing organizations) maintain rules that prohibit employees of the futures SROs (including members of the SROs* governing boards and committees) from trading in futures and options where the employees have access to material non-public information concerning such futures or options interest. Because this provision does not cover corporate insiders, it has been described as *a relatively narrow rule when compared with the broader prohibitions under the federal securities laws.* 1 Philip McBride Johnson & Thomas Lee Hazen, Commodities Regulation 2.05 (3d ed. 1998).
Therefore, if trading in single stock futures were permitted, there is a very real risk that illicit profits could be reaped with impunity in the futures markets by exploiting insider information. Curbing insider trading helps maintain investors' strong confidence in the integrity of our securities markets. This high degree of confidence could deteriorate rapidly if users of equity-based futures are allowed to freely trade on non-public information.
The futures exchanges have proposed to remedy this serious deficiency by giving the SEC insider trading authority over futures on single stocks and narrow-based stock indexes. Unfortunately, this attempt to strengthen the oversight of these futures is an ill-conceived quick-fix that would create more problems than it solves.
For instance, to ensure truly effective surveillance and enforcement of our insider trading rules as applied to equity-based futures, the Commission would need the same type of authority over futures exchanges and market participants that it now has over their securities counterparts. This would include the ability to oversee futures exchange surveillance programs that are a critical component of efforts to detect and deter insider trading. If the Commission were provided this necessary oversight authority, the compliance costs for futures exchanges would increase significantly, as the exchanges would bear the burden of oversight by both the CFTC and SEC. It appears quite costly and inefficient to force these entities to incur significant additional compliance expenses to adhere to a single section of an entirely different regulatory scheme.
Page 113 PREV PAGE TOP OF DOC Segment 1 Of 4 A delegation of insider trading oversight would seem to represent the first step of an incremental merger of the SEC and CFTC. While the Commission has not taken a position in favor of, or against, such a merger, if after a thorough review Congress determines a merger is appropriate, it should complete the combination in a quick, efficient manner rather than in a piecemeal fashion. A step-by-step consolidation prolongs the process, complicates unnecessarily the regulatory scheme, and creates uncertainty among market participants.
Finally, without an increase in resources, the SEC would be ill-equipped to monitor and detect insider trading in equity-based futures. Commission staff in the Divisions of Market Regulation and Enforcement do a remarkable job with the limited resources available now, especially in light of the recent surge in on-line trading and the accompanying concerns regarding Internet fraud. The Commission believes it would be difficult for the staff to effectively oversee trading in the futures markets without an increase in personnel.
As Congress has previously recognized, the securities and futures markets are regulated differently owing to their different functions and purposes. The Federal securities laws were designed to protect investors. This goal remains fundamental to the SEC's mission today. In contrast, the Federal commodity futures laws were originally designed to regulate speculating and hedging in agricultural commodities.
The landscape of the futures markets has changed substantially over the past several decades as the range of exchange-traded products has evolved from being entirely agricultural to primarily financial and non-agricultural. In 1951, for example, the Commodity Exchange Authority regulated futures trading on 20 commodities, all of which were agricultural. When the legislation creating the CFTC became effective on April 21, 1975, approximately 41 contract markets were already designated for futures trading by the Secretary of Agriculture. Each of the commodities underlying the 41 approved futures contracts was agricultural. By September 30, 1998, however, of the 706 contract markets designated for futures and futures options trading, 571 (81%) were for non-agricultural commodities (e.g., stock indexes, foreign currencies, interest rates, energy, metals, electricity, and insurance).
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The futures exchanges themselves have noted that the commodity futures laws are not designed to deal effectively with the increasingly sophisticated, non-agricultural products traded on the futures exchanges.
However, any attempt at wholesale regulatory reform would produce enormous costs for all affected parties and their constituents. Although at times the current regulatory scheme is complicated, and sometimes burdensome, the SEC believes that, overall, the system works.
There are ways to achieve meaningful regulatory reform on less than a wholesale basis. Unfortunately, the approach taken by the futures exchanges does not bridge the existing regulatory divide for securities and futures products. Single stock and narrow-based stock index futures would be offered under a regulatory scheme that differs profoundly from the regulatory scheme governing the underlying stocks. Creating such a bifurcated regulatory scheme is not the solution that best addresses this issue.
Furthermore, rather than attempt to narrow the regulatory disparities between futures and securities, the futures exchanges are advancing measures that would widen the regulatory chasm by cutting back the Federal regulatory oversight of the futures markets. If this were to occur in conjunction with single stock futures, it would create tremendous pressure to deregulate the securities markets. This presents a recipe for disastera race to the lowest level of regulation without regard for the negative consequences of eliminating important protections. It is foreseeable that as competition for equity-based business intensified between securities and futures markets, exchanges would want to do away with safeguards simply to obtain a competitive advantage. While regulators should seek to encourage competition, they should be careful not to create incentives that would undermine their abilities to protect investors and oversee markets.
Page 115 PREV PAGE TOP OF DOC Segment 1 Of 4 The futures exchanges' proposal, in the name of deregulation, would shift significant authority from the regulator to market participants. If they prevail in scaling back the regulatory role of the CFTC, the futures markets will be free to establish their own rules, including rules governing trading and listing standards for new products, without receiving the approval of the CFTC. While the SEC believes that self-regulation plays an important role in maintaining fair and honest markets, it should be an adjunct to effective oversightnot a substitute.In the Committee Report accompanying the legislation that codified the Accord, the House Committee on Energy and Commerce noted that the Government Accounting Office had described the limitations on futures industry self-regulation as follows:
The limitations on self-regulation are traceable to the nature of commodity exchanges as voluntary organizations composed of members whose primary motivation is - understandably - profit making. The exchange member*s profit motive and his role as an enforcer of rules against himself and other members (e.g., as an exchange board member or member of an exchange governing or disciplinary committee) can give rise to conflicts of interest.
H.R. Rep. No. 565, 97th Cong., 2d Sess., pt. 2, at 13 (1982).
Our financial markets remain the envy of the world because of their depth and liquidity, innovative products, and the universal belief that they are fair. The Commission believes that strongbut sensibleregulation is the key to protecting the integrity of the markets. The Commission is concerned that the futures exchanges' proposal cannot ensure that this basic tenet is satisfied.
In the following days of these hearings, certain witnesses are likely to criticize the accord and the role of the SEC in reviewing proposed futures contracts on securities indexes. the accord gives the SEC the authority to determine whether a proposed securities index futures contract satisfies the minimum requirements of the accord. Specifically, the futures contract must: (1) be cash-settled; (2) not be readily susceptible to manipulation; and (3) measure and reflect a substantial segment of the securities market. If the SEC determines that a proposed futures contract fails to meet any one of these requirements, the CFTC may not permit trading in that contract.
Page 116 PREV PAGE TOP OF DOC Segment 1 Of 4 In December 1997, the Commission performed its statutorily-mandated review of two securities index futures contracts proposed by the Chicago Board of Trade that were based on the Dow Jones utility and transportation indexes. The Commission objected to the Chicago Board of Trade's proposal because we determined that the proposed Dow contracts did not satisfy the statutory criteria under the accord. Specifically, the utilities and transportation indexes, both containing a small number of component stocks, The Dow Jones Utilities Average Index included 15 stocks and the Dow Jones Transportation Average Index included 20 stocks.
did not properly reflect a substantial segment of the U.S. equities market. The Chicago Board of Trade appealed our determination to the 7th Circuit Court of Appeals, where the matter is still pending.
The futures exchanges believe that our Dow determination demonstrates that the SEC is a barrier to new products and shows that the accord is ''unworkable.'' The Chicago Board of Trade has claimed that the Accord has *unworkable and discriminatory product restrictions.* See Letter from Thomas R. Donovan, President and Chief Executive, Chicago Board of Trade, to Senator Richard Lugar, Chairman, Committee on Agriculture, Nutrition, and Forestry, dated March 18, 1999.
However, since the accord was codified, we have worked with the futures exchanges and the CFTC on nearly 70 stock index futures proposalsthe Dow proposal is the only instance since November 1983 where we have formally objected to a proposal.
The Commission believes that it has consistently cooperated and worked in good faith with the CFTC and the futures exchanges to facilitate the trading of new and innovative futures contracts. For example, since the Dow determination last July, the Commission worked with the Chicago Mercantile Exchange to introduce a new futures contract on a REIT index, and the Commission recently worked with the Kansas City Board of Trade to introduce a new Internet stock index futures contract. In both of these instances, SEC staff made suggestions and raised important questions regarding the structure of the indexes, and, in doing so, guided the exchanges in developing products that fit within the safeguards of the accord. These examples demonstrate that the accord permits the trading of industry sector products, and that the SEC remains flexible in interpreting the accord to allow futures exchanges to offer novel equity-based products, provided they have adequately addressed the statute's anti-manipulation concerns.
Page 117 PREV PAGE TOP OF DOC Segment 1 Of 4 II. PROVIDING LEGAL CERTAINTY FOR OTC DERIVATIVES TRANSACTIONS
The OTC derivatives market has experienced tremendous growth over the past two decades. In part, this growth can be attributed to the significant benefits OTC derivatives provide to corporations, financial institutions, and institutional investors by allowing them to isolate and manage risks associated with their business activities or financial assets. Although derivatives can be dangerous if misused, when market participants establish adequate internal controls, financial losses can be avoided, or at least minimized.
In order for this market to continue to develop efficiently and effectively, it is essential to provide legal certainty for OTC swaps and other OTC derivative transactions effected between institutional counterparties. OTC transactions in securities-based swaps should be excluded from the CEA in order to provide such legal certainty for participants in this market. The market in these transactions has developed outside of the scope of CFTC regulation and does not affect, to any great extent, the price discovery or liquidity functions performed by regulated exchange markets.
An exclusion from the CEA would preserve the interest of the SEC in securities-based products while providing the legal certainty that the products would not be deemed illegal futures. An exclusion would continue to uphold the Shad-Johnson ban against futures on individual securities, as well as the SEC's consultative role regarding securities index futures, while ensuring that the CEA would not be applied to institutional OTC transactions. In addition, this is the approach currently used to exclude transactions in Government securities and foreign currency from the CEA by means of the Treasury Amendment.
However, it is not appropriate to codify, and extend to Shad-Johnson, the exemptions from the CEA for swaps and other OTC derivative transactions.17 C.F.R. Part 35.
These rules were adopted in 1993 pursuant to exemptive authority granted to the CFTC under the Futures Trading Practices Act of 1992.P.L. No. 102-546; 106 Stat. 3590 (1992).
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Although most market participants did not consider swaps to be futures under the CEA,The views of market participants were based, in part, on guidance provided by the CFTC. In 1989, the CFTC issued a policy statement concerning swap transactions in which it expressed the view that ''most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations.'' 54 FR 30694 (July 21, 1989). The CFTC provided additional guidance to OTC derivatives traders when it adopted its Part 35 rules in 1993. In the release adopting the rules, the CFTC stated that the issuance of the rule should not be construed as reflecting any determination that the swap agreements covered are subject to the CEA, ''as the [CFTC] has not made and is not obligated to make any such determination.'' 58 FR 5588 (January 14, 1993).
these exemptive rules provided some assurance that a private litigant would not claim that a swap was an illegal future. The CFTC's exemptive authority does not extend to the Shad-Johnson Accord. As a result, some market participants believe that legal uncertainty continues to impair the development of equity swaps due to the risk that equity swaps would be deemed futures on single stocks in violation of the Shad-Johnson Accord.
While it is important to ensure that securities-based swaps do not fall within the CEA, the Commission would be concerned by any proposed efforts to provide legal certainty through a broader exemptive approach. First, a broad exemptive approach would provide OTC transactions between institutional counterparties with an exemption from all provisions of the CEA, including the Shad-Johnson Accord. The SEC is concerned that this could lead to pressure for additional exemptions from Shad-Johnson for exchange-traded futures.See Consolidated Testimony of the Futures Exchanges of the United States before the Committee on Agriculture, Nutrition and Forestry, United States Senate (February 11, 1997).
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Second, an exemptive approach could allow some market participants to argue that because swaps are exempted from the CEA, they were presumed to be futures in the first place. Otherwise, no exemption would have been needed. Based on this presumption, some would argue that because the CFTC has exclusive jurisdiction over futures, exempted swap products would be free from oversight by other Federal regulators.See, e.g., Letter from Jean A. Webb, Secretary, CFTC, to Jonathan G. Katz, Secretary, SEC dated February 26, 1998. (Comment letter submitted in response to SEC*s OTC derivative dealers proposed rulemaking, File No. S7-30-97).
Indeed, many of the jurisdictional problems that arise in the context of OTC and exchange-traded derivatives could be minimized if the CEA did not provide the CFTC with exclusive jurisdiction over financial product-based derivatives. Exclusive jurisdiction was largely designed to address issues associated with the pricing and efficiency of markets for physical commodity futures and to preempt state gambling laws. As applied in the context of securities regulation, the CFTC's exclusive jurisdiction has had the unintended consequence of impeding the SEC from fulfilling its statutory obligation to regulate the Nation's securities markets.
The Commission is participating in the President's Working Group on Financial Markets' study of the OTC derivatives market which should provide Congress with information on OTC derivative instruments, participants, negotiation and execution of transactions, and clearance and settlement. The study will evaluate whether additional regulatory safeguards for OTC derivatives are necessary.
The goal of this study is to develop appropriate recommendations for additional changes in statutes, regulations, and policies to improve operation of the market; to enhance legal certainty for OTC derivative instruments; and to permit the development of new hybrid products. Among other things, the Working Group will need to assess whether additional steps should be taken to safeguard the increasingly sensitive and interconnected financial markets, where risks can become magnified by volume, technology, and complexity.
Page 120 PREV PAGE TOP OF DOC Segment 1 Of 4 III. CONCLUSION
The Commission believes that the accord continues to serve an important purpose and that overall it has operated quite well during the past 17 years. The repeal of the accord and the offering of futures on single stocks and narrow-based stock indexes would have highly negative consequences for our capital markets. We urge Congress to protect the integrity of these vital markets by preserving the accord.
With respect to the regulation of the OTC derivatives market, we believe that, at a minimum, steps should be taken to improve the legal certainty of OTC derivative instruments. However, other issues should also be explored. To further analyze these issues, the Commission continues its work with fellow members of the President's Working Group to study the OTC derivatives market and develop a coordinated response in this area.
That concludes my testimony. I would be happy to answer any questions you might have.
Testimony of Gary Gensler
Chairman Ewing, Ranking Member Condit, and Members of the committee, it is an honor to appear before you today to discuss issues involving the reauthorization of the Commodity Futures Trading Commission and the regulation of derivatives. These topics are of considerable importance to both the agricultural and financial communities.
The U.S. derivatives markets perform a critical role in our economy. The innovations and advances in this market also have helped ensure the global leadership of our financial markets and institutions. The dramatic development of this market, however, has occurred on the basis of complex and fragile legal and legislative underpinnings.
At the request of members of Congress, the President's Working Group on Financial Markets is preparing a study of the over-the-counter derivatives market. It is examining what changes, regulatory or legislative, may be appropriate to reduce systemic risk, to eliminate legal uncertainty, to curtail regulatory arbitrage, and to address the potential use of derivatives for fraud or manipulation. The Working Group agencies have started drafting the derivatives report and we hope to complete it later this year.
Page 121 PREV PAGE TOP OF DOC Segment 1 Of 4 In order to meet current and future demands of the U.S. and global financial markets, Treasury believes that the Commodity Exchange Act needs to be modernized. We look forward to working with Congress in order to resolve important legal certainty issues related to the CEA.
THE DERIVATIVES MARKETS
OTC derivatives directly and indirectly support higher investment and growth in living standards in the United States and around the world. Derivatives facilitate domestic and international commerce and support a more efficient allocation of capital across the economy. They can help improve the functioning of financial markets by potentially raising liquidity and narrowing the bid-asked spreads in the underlying cash markets. Derivatives can also present challenges, however, in the area of risk management. In addition, market participants can assume extensive leverage through derivatives, as we saw in the case of Long-Term Capital Management.
The OTC derivatives market is a vast, global industry. According to the BIS, the market had reached a notional value of around $70 trillion in June, 1998. The dramatic growth of the market in recent years is testament not merely to the dynamism of modern financial markets, but to the numerous benefits that derivatives provide for American businesses.
Derivatives can help companies of all sizes, and in all industries, to hedge and manage risk that already exists, by transferring that risk to others who are more willing and able to bear such risk. For example, wheat farmers can effectively protect against price fluctuations of their crop during the growing season by entering into futures or forward contracts.
Second, derivatives markets provide pricing information relevant to the underlying markets. This helps the underlying markets to become more efficient.
Third, derivatives markets can help to increase the liquidity of the underlying markets. Government securities dealers use futures contracts on Treasury securities to manage their risks, and these futures markets enhance the liquidity of the Government securities market and lower the spread between bid and offer prices.
Page 122 PREV PAGE TOP OF DOC Segment 1 Of 4 Fourth, derivatives contracts can also be used to lower financing costs. For example, a firm may want to lock in an interest rate for a long period of time. Rather than issuing fixed-rate long-term debt directly into the market, the firm may find that it is cheaper to borrow using variable rate debt and a swap to effectively fix the interest cost.
On the other hand, derivatives can also present certain challenges and issues, which the Working Group will study.
First, the complexity of some derivative instruments leads to issues of appropriateness and risk management for customers and counterparties. There have clearly been some lapses in recent years. How serious a problem this is and whether and how the Government should be involved are questions being studied by the President's Working Group on Financial Markets.
Second, the fast-evolving derivatives markets have created new challenges for risk management. All financial market participants need effective systems to monitor and manage market risk, credit risk, and counterparty relations for derivative products. In addition, firms face liquidity risk, operating risk, and the risk that legal uncertainty could impel a counterparty to repudiate a contract. As evidenced in last year's global financial crisis, enhanced credit risk management is of particular importance for financial institutions entering into derivatives transactions with other financial institutions.
Third, derivatives can allow market participants to assume substantial leverage. The amount of cash or collateral that needs to be put up on entering into a derivatives contract is often relatively small in comparison to the amount of risk being assumed.
Fourth and finally, questions have also been raised about the potential for systemic risk associated with derivatives. The Working Group is studying whether the features of derivatives trading pose special risks to the financial system.
Page 123 PREV PAGE TOP OF DOC Segment 1 Of 4 CFTC REAUTHORIZATION ISSUES
Treasury believes that Congress should modernize the CEA, in order to clarify the status of legitimate products and markets. Troublesome questions have been raised about the legality of certain portions of the OTC derivatives market. Derivatives contracts are based on a certain understanding of the law; however, if this interpretation is wrong, then these contracts become unenforceable. The current legal uncertainty may also impede certain initiatives, such as the development of clearinghouses, which can reduce systemic risk. The Working Group is examining the overall regulatory structure, including what sort of regulation for OTC derivatives markets may be appropriate, and by whom.
The statute that is now the Commodity Exchange Act was originally enacted in the 1920's to establish a basis for the Federal regulation of the agricultural futures markets. At that time, regulators' primary concern was the potential for manipulation of agricultural commodities that are in finite supply, such as wheat and corn. For the most part, the CEA has served these markets well.
The current confusion and uncertainty concerning the scope of the CEA has roots in the 1974 legislation that created the CFTC. That legislation significantly broadened the CEA by amending the definition of ''commodity,'' so that the term is essentially open-ended. However, the legislation left the term ''futures contract'' undefined. As a consequence, to take an example, interest rates are now a ''commodity'' for purposes of the CEA, but it is unclear what types of off-exchange transactions tied to interest rates are futures contracts. Because it is possible to interpret the CEA, after the substantial amendments made in 1974, in a very broad manner, jurisdictional and interpretive disputes have occurred among interested parties, which include both Federal regulators and private industry groups. These disputes have been accentuated by provisions of the CEA that give the CFTC ''exclusive jurisdiction'' over transactions governed by the statute.
Page 124 PREV PAGE TOP OF DOC Segment 1 Of 4 Moreover, significant changes have occurred in derivatives markets over the past 25 years, creating new legal and jurisdictional issues that were not foreseen in 1974. Financial derivatives now far surpass agricultural contracts in notional value. Bilaterally negotiated contracts on the OTC markets now dwarf trading on the exchanges. Additionally, electronic trading systems have been introduced, and clearing and netting systems have been improved.
There have been good-faith efforts to resolve some of these disputes, such as the Shad-Johnson Accord, which was enacted into law in 1982, and the CFTC's exemptive statement, published in 1993 in accordance with the Futures Trading Practices Act of 1992.
Several key issues related to legal certainty are still unresolved, however. The Working Group will address these issues in its study of the OTC derivatives market.
First, the modification of the Treasury Amendment by Congress is needed, in order to clarify that certain markets are excluded from the CEA. Enacted at the request of the Treasury Department in 1974, the Treasury Amendment currently excludes from the coverage of the CEA all transactions in foreign currency, Government securities, and certain other instruments, unless the transactions involve a sale for future delivery conducted on a ''board of trade.'' This exclusion prevents duplicative regulation of markets that are vital to international trade and the financing of Government operations, thereby strengthening the U.S. economy and lowering the cost of Government borrowing. Unfortunately, the Treasury Amendment has been the subject of a spate of litigation in recent years, and the courts have succeeded in resolving only some of the issues presented.
In order to clarify the status of legitimate markets under the Treasury Amendment, we believe that Congress should clarify that the term ''board of trade,'' as used in the Treasury Amendment, means an organized exchange. In addition, Treasury has in the past suggested that Congress should provide the CFTC with anti-fraud authority over foreign currency ''bucket shops'' that prey on unsophisticated retail investors.
Page 125 PREV PAGE TOP OF DOC Segment 1 Of 4 Second, the CFTC's Swap Exemption, which provides the legal basis for much of the OTC derivatives market, has been only partially successful in alleviating legal uncertainty. The Swap Exemption reflects the implicit consensus that has existed for the past 10 years: swap transactions should not be regulated under the CEA, whether or not a plausible legal argument could be made that any of these transactions are potentially covered by the CEA. It is our view, and that of both the Federal Reserve and the SEC, that swaps are not futures under the CEA, and that the rigidity of the CEA is not well suited to regulation of the institutional swaps market. In light of these considerations, Congress should amend the CEA to clarify the legal status of swap agreements.
A conclusion that the CEA is not suited to regulation of swap transactions does not necessarily imply a conclusion that such transactions should be unregulated, however. The Working Group is wrestling with many of the questions raised by the CFTC in its Concept Release, to determine what sort of regulation for these markets may be appropriate. The Working Group is also examining the issues surrounding the development of electronic trading systems and clearinghouses for swaps. These innovations have the potential to enhance market liquidity and reduce systemic risk, but some would argue that they blur the lines between swaps and futures markets.
Third, the Working Group is considering a special set of legal certainty questions faced by swaps that involve securities governed by the Federal securities laws. The CFTC lacks the legal authority to exempt most futures based on securities from the CEA. Therefore, the market for swaps based on non-exempt securities is based on a conclusion that these instruments are not futures contracts. Statements in the CFTC's Concept Release cast doubt on this conclusion. Treasury believes that a more permanent legislative clarification of the status of these instruments is necessary.
The derivatives market has grown and evolved without resolving these CEA jurisdictional issues, but this arrangement is fragile. Markets operate best in an environment of legal certainty. Market participants must be able to ascertain readily the regulatory requirements that apply to them and have confidence in the enforceability of their own obligations and those of their counterparties.
Page 126 PREV PAGE TOP OF DOC Segment 1 Of 4 THE WORKING GROUP'S DERIVATIVES STUDY
The President's Working Group on Financial Markets is also addressing, as part of its report on derivatives, a number of other topics related to derivatives markets. Many of these topics were raised by the CFTC in its Concept Release.
Market manipulation. The Working Group is studying whether regulation is appropriate to deter any potential manipulation that may exist in the OTC derivatives market.
Fraud and customer protection. The Working Group will examine whether there is a need for specialized anti-fraud or customer protection rules in certain markets, or for certain market participants.
Regulatory parity. Some valid questions have been raised concerning parity among market participants. For example, is it appropriate to make the current regulatory distinctions between on- and off-exchange trading, or between cash and derivatives markets?
Systemic risk. The Working Group is examining how the derivatives markets may affect financial stability, and whether supervisory or regulatory policies can reduce the potential for systemic risk.
International Harmonization. The Working Group is examining how best to achieve international harmonization of regulation of OTC derivatives.
We caution, however, that the Working Group may not be able to reach a consensus on all of the very complex jurisdictional and regulatory issues that will be addressed by the study. Whether or not the agencies are able to reach a consensus on a set of recommendations, we will endeavor to provide a comprehensive assessment of the issues to aid Congress in its efforts to design a workable structure for the oversight of the financial markets going forward.
We appreciate the concerns that have been raised about the need for a level playing field among derivatives markets participants. The Working Group will need to consider important issues regarding the regulation of exchange-traded derivatives and OTC derivatives. There are important differences, however, between exchange-traded derivatives and OTC derivatives that may justify different regulatory approaches. For example, we believe that special aspects of the institutional markets for instruments covered by the Treasury Amendment should continue to be excluded from the CEA.
Page 127 PREV PAGE TOP OF DOC Segment 1 Of 4 We look forward to working with this committee, and with other members of Congress and interested parties as we work to resolve these issues in a way that safeguards America's position in this fast-developing global market.
I would be happy to respond to any questions the committee may have. Thank you.
Testimony of Patrick M. Parkinson
I am pleased to be here today to present the Federal Reserve Board's views on whether it is necessary to modernize the Commodity Exchange Act (CEA). The Board believes that modernization of the act is essential. The reauthorization of the Commodity Futures Trading Commission (CFTC) offers the best opportunity to make the necessary changes. If this opportunity is lost, the Board is concerned that market participants will abandon hope for regulatory reform in the United States and take critical steps to shift their activity to jurisdictions that provide more appropriate legal and regulatory frameworks.
THE NEED FOR MODERNIZATION OF THE CEA
The key elements of the CEA were put in place in the 1920's and 1930's to regulate the trading on exchanges of grain futures by the general public, including retail investors. The public policy objectives were, and are, clear: to deter market manipulation and to protect investors.
The objective of the Grain Futures Act of 1922 was to reduce or eliminate ''sudden or unreasonable fluctuations'' in the prices of grain on futures exchanges. The framers of the act believed that such price fluctuations reflected the susceptibility of grain futures to manipulation. During the latter part of the nineteenth century and the early part of the twentieth century, attempts to corner the markets for wheat and other grains, while rarely successful, often led to temporary, but sharp, increases in prices that engendered large losses to short sellers of futures contracts who had no alternative but to buy and deliver grain under their contractual obligations. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to corner a grain market. Furthermore, because grain futures prices were widely disseminated and widely used as the basis for pricing grain transactions off the exchanges, price fluctuations from attempts at manipulation had broad ramifications for the agricultural sector and, given the relative size of the agricultural sector at the time, for the economy as a whole.
Page 128 PREV PAGE TOP OF DOC Segment 1 Of 4 The Commodity Exchange Act of 1936 introduced provisions to protect retail investors in agricultural futures. Retail participation in these markets had been increasing and was viewed as beneficial, but retail investors may lack the knowledge and sophistication to protect themselves effectively against fraud or to manage counterparty credit exposures effectively. Safeguards against fraud and counterparty losses were intended to foster their participation in these markets.
While the objectives of the CEA have not changed since the 1930's, what are now called the derivatives markets have undergone profound changes. On the futures exchanges themselves, financial contracts now account for about 70 percent of the activity, and retail participation in most financial contracts is negligible. Outside the exchanges, enormous markets have developed in which banks, corporations, and other institutions privately negotiate customized derivatives contracts, the vast majority of which are based on interest rates or exchange rates.
The Board believes that the application of the CEA to the trading of financial derivatives by professional counterparties is unnecessary. Prices of financial derivatives are not susceptible to, that is, easily influenced by, manipulation. Some financial derivatives, for example, Eurodollar futures or interest rate swaps, are virtually impossible to manipulate, because they are settled in cash, and the cash settlement is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supply. For other financial derivativesfor example, futures contracts for Government securitiesmanipulation of prices is possible, but it is by no means easy. Large inventories of the instruments are immediately available to be offered in markets if traders endeavor to create an artificial shortage. Furthermore, the issuers of the instruments can add to the supply if circumstances warrant. This contrasts sharply with supplies of agricultural commodities, for which supply is limited to a particular growing season and finite carryover.
In addition, professional counterparties simply do not require the kind of investor protections that the CEA provides. Such counterparties typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgment. And, if they believe they have been defrauded, they are quite capable of seeking restitution through the legal system. Nor is there any obvious public policy reason to foster direct retail participation in financial derivatives markets.
Page 129 PREV PAGE TOP OF DOC Segment 1 Of 4 Most professional counterparties in financial derivatives markets view the regulatory protections imposed by the CEA as unnecessary and burdensome. Although to date there is no clear-cut evidence of a significant migration of activity to other jurisdictions, should the next CFTC reauthorization not provide for modernization of the regulation of financial derivatives, this could changeperhaps quickly. Rapid advances in technology are making electronic trading systems increasingly attractive, both as an alternative to open outcry trading on exchanges and as an alternative to the use of telephones and voice brokers in the over-the-counter (OTC) markets. Such electronic trading systems might develop in the United States, but if the United States continues to impose what market participants perceive as unnecessary regulatory burdens, such systems could instead develop abroad. In particular, much of the existing activity in financial derivatives consists of transactions between large global financial institutions, all of which already have substantial operations in London. Regulatory burdens on financial derivatives transactions in the United Kingdom are generally perceived to be significantly lighter than those currently imposed by the CEA, yet participants have considerable confidence in the integrity of the UK markets. If unnecessary regulatory burdens in the United States prompt global institutions to join, or even develop, a London-based electronic trading system for financial derivatives, the United States would suffer a serious and perhaps irreversible blow to its international competitiveness in financial services.
MODERNIZING THE CEA: OTC DERIVATIVES
In the Board's view, then, significant changes in the CEA are appropriate and the time to make those changes is in the next CFTC reauthorization. In the case of privately negotiated derivatives transactions between institutions, the Board has supported exclusion of such transactions from coverage under the CEA in the past and continues to do so. In these markets, private market discipline appears to achieve the public policy objectives of the CEA quite effectively and efficiently. Counterparties to these transactions have limited their activity to contracts that are very difficult to manipulate. A global survey conducted by central banks and coordinated by the Bank for International Settlements revealed that, as of June 1998, 97 percent of OTC derivatives were interest rate or foreign exchange contracts. The vast majority of these OTC contracts are settled in cash rather than through delivery. Cash settlement typically is based on a rate or price in a highly liquid market with a very large or virtually unlimited deliverable supplyfor example, LIBOR or the spot dollar-yen exchange rate.
Page 130 PREV PAGE TOP OF DOC Segment 1 Of 4 To be sure, some types of OTC contracts that have a limited deliverable supply, such as equity swaps and some credit derivatives, are growing in importance. However, unlike agricultural futures, for which failure to deliver has additional significant penalties, costs of failure to deliver in OTC derivatives are almost always limited to actual damages. Thus, manipulators attempting to corner a market, even if successful, would have great difficulty inducing sellers in privately negotiated transactions to pay significantly higher prices to offset their contracts or to purchase the underlying assets.
Finally, the prices established in privately negotiated transactions are not used directly or indiscriminately as the basis for pricing other transactions. Counterparties in the OTC markets can be expected to recognize the risks to which they would be exposed by failing to make their own independent valuations of their transactions, whose economic and credit terms may differ in significant respects. Moreover, they usually have access to other, often more reliable or more relevant, sources of information on valuations. Hence, any price distortions in particular transactions would not affect other buyers or sellers of the underlying asset.
Professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from counterparty insolvencies and from fraud. In general, they have managed credit risks effectively through careful evaluation of counterparties, the setting of internal credit limits, and judicious use of netting and collateral agreements. In particular, they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. This, in turn, provides substantial protection against losses from fraud. Dealers are established institutions with substantial assets and significant investments in their reputations. When they have engaged in deceptive practices, the professional counterparties that have been victimized have been able to obtain redress under laws applicable to contracts generally. Moreover, the threat of legal damage awards provides dealers with strong incentives to avoid misconduct. A far more powerful incentive, however, is the fear of loss of the dealer's good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities.
Page 131 PREV PAGE TOP OF DOC Segment 1 Of 4 The effectiveness of these incentives was confirmed in a 1995 survey of end-users of OTC derivatives that was conducted by the General Accounting Office. When asked if they were satisfied with derivatives dealers' sales practices, 85 percent of users of plain vanilla derivatives and 79 percent of users of more complex derivatives indicated satisfaction. The great majority of the remainder responded neutrally rather than indicating that they were dissatisfied.
MODERNIZING THE CEA: CENTRALIZED EXECUTION OR CLEARING OF FINANCIAL DERIVATIVES
Recently, some participants in the OTC markets have shown interest in utilizing centralized mechanisms for clearing or executing OTC derivatives transactions. For example, the London Clearing House plans to introduce clearing of interest rate swaps and forward rate agreements in the second half of 1999, and several entities are developing electronic trading systems for interest rate and foreign exchange contracts. Such mechanisms could well reduce risk and increase transparency in derivatives markets. However, their development in the United States is being impeded by the specter that the CEA might be held to apply to transactions executed or settled through such mechanisms. Application of the act not only is perceived as entailing unnecessary regulatory burdens, but also, because of the exchange trading requirement of the act, it raises questions about the legal enforceability of the contracts traded or cleared.
Provided that participation is limited to professional counterparties acting as principals, the Board believes financial derivatives executed or cleared through such centralized mechanisms should nonetheless be excluded from the CEA. The use of such mechanisms would not make these transactions any more susceptible to manipulation than when the transactions are bilaterally executed and cleared. Nor would their use impair the demonstrated ability of professional counterparties to protect themselves from losses from fraud.
Because clearing concentrates and often mutualizes counterparty risks, some type of Government oversight of clearing systems may be appropriate. However, it is not obvious that regulation of such clearing facilities under the CEA would always be the best approach. For example, the Board sees no reason why a clearing agency regulated by the Securities and Exchange Commission should not be allowed to clear OTC derivatives transactions, especially if it already clears the instruments underlying the derivatives. Likewise, if a clearing facility were established in the United States for privately negotiated interest rate or exchange rate contracts between dealers, most of which were banks, oversight by one of the Federal banking agencies would seem most appropriate.
Page 132 PREV PAGE TOP OF DOC Segment 1 Of 4 MODERNIZING THE CEA: HARMONIZING REGULATION OF THE OTC MARKETS AND FUTURES EXCHANGES
Beyond question, the centralized execution and clearing of what to date have been privately negotiated and bilaterally cleared transactions would narrow the existing differences between exchange-traded and OTC derivatives transactions. However, that is not a reason to extend the CEA to cover OTC transactions. As we have argued, doing so is unnecessary to achieve the public policy objectives of the act. Moreover, as the economic differences between OTC and exchange-traded contracts are narrowing, it is becoming more apparent that OTC market participants share this conclusion; their decision to trade outside the regulated environment implies they do not see the benefits of the act as outweighing its costs.
Instead, the Federal Reserve believes that the futures exchanges should be allowed to compete in offering such services to professional counterparties, free from the constraints and burdens of the CEA. The conclusion that centralized mechanisms for professional trading of financial derivatives do not require regulation under the act is valid even if those centralized mechanisms are operated by entities that also operate traditional futures exchanges.
If an exchange chooses to clear professional transactions in financial derivatives through the same clearing house that clears its traditional CEA-regulated contracts, then the clearing should be regulated by the CFTC. But exchanges should be allowed to choose to establish a separate clearing system for such transactions that would be overseen by another regulator. In general, with respect to such transactions, the exchanges should have the same options and be subject to the same constraints as competing service providers.
To sum up, the Commodity Exchange Act was designed in the 1920's and 1930's to regulate the trading of grain and other agricultural futures by the general public, including retail investors. Since then, what are now called the derivatives markets have undergone profound changes. Both on futures exchanges and in the OTC markets, financial derivatives now account for the great bulk of the activity. Counterparties to financial derivatives transactions are predominantly institutions and other professional counterparties; retail participation in most of these markets is negligible. Financial derivatives are not susceptible to manipulation and professional counterparties do not need the protections that retail investors do.
Page 133 PREV PAGE TOP OF DOC Segment 1 Of 4 The Board believes that privately negotiated derivatives transactions between professional counterparties should be excluded from the act. Furthermore, the exclusion should apply to centrally executed or cleared transactions, provided that any clearing system is subject to official oversight. Futures exchanges should be allowed to compete as operators of such trading or clearing systems, free from the burdens and constraints of the act.
AMERICAN COTTON SHIPPERS ASSOCIATION
May 14, 1999
HON. THOMAS W. EWING, CHAIRMAN,
Subcommittee on Risk Management & Specialty Crops
Committee on Agriculture
Washington, DC 20515
Re: Agricultural Trade Options
DEAR CHAIRMAN EWING:
Attached for your consideration and inclusion in the record of the May 1820 hearings on the Commodity Futures Trading Commission Reauthorization is a copy of ACSA's April I6 letter to Commodity Futures Trading Commission Member David D. Spears in his capacity as Chairman of the Commission's Agricultural Advisory Committee.
The letter requests that since the Commission has acknowledged that its Pilot Program is inoperative that it give serious consideration to our recommended changes which could establish a workable and useful trade options program.
Page 134 PREV PAGE TOP OF DOC Segment 1 Of 4 Respectfully submitted
NEAL P. GILLEN
Executive Vice-President & General Counsel
AMERICAN COTTON SHIPPERS ASSOCIATION
April 16, 1999
HON. DAVID D. SPEARS
Commodity Futures Trading Commission
Three Lafayette Centre
I155 21st Street. N.W.
Washington, DC. 20581
Re. Agricultural Trade Options
DEAR COMMISSIONER SPEARS:
Regretfully, the April 21 meetings date of the Agricultural Advisory Committee precludes the attendance of Joe Nicosia who will be at the meeting of the Board of Trade of the city of New York. Further. I am required to be in Memphis that day for the beginning of the annual meeting of our federated association, the Southern Cotton Association Therefore, we submit the following comments regarding trade options:
The use of risk management tools by prudent market participants should come with the assurance that all of the risks will be in the market and that there are minimal risks inherent in the product offered for use or in dealing with those offering the off-exchange product.
It is our view that the producer and the textile mill, using the same caution or prudence in dealing with a buyer or seller of a spot or forward contract, will be assured of the same protection if the transaction involves the use of an off-exchange option product. Prudence dictates that he or she should be familiar with the party through previous dealing or reliable credit references, and the contractual relationship should provide for the resolution of any disagreements through arbitration.
Page 135 PREV PAGE TOP OF DOC Segment 1 Of 4 In our initial comments to the Commission. on the Advance Notice of the Proposed Rule in July 1997, we raised the following questions:
Should the Commission address the financial qualifications of the entity offering the off-exchange product?
Should the Commission determine who is qualified to offer agricultural trade options?
Should the commission require that offering parties report their trade options activity?
It is our view that each of these questions should be answered in the negative
In December 1997, in our comments on the proposed rule, we advised the Commission that ''ACSA members will not participate in the pilot program, unless the Commission undertakes a review of its draconian restrictions and substantially modifies the proposed regulations. The proposal is so restrictive and expensive that even the well established and highly capitalized firms see no commercial benefit being derived by producers or textile mills by providing the product suggested by the Commission.''
Now that the Commission has acknowledged that its Pilot Program is inoperative we urge it to give serious consideration to our views and to establish a workable and useful trade options program. To accomplish this end, a number of changes must be made, including those discussed in our comments to the Commission on the following areas:
Physical Delivery - The Commission denies agricultural producers the right to pay a premium to exercise an option not to deliver, an innovation that would have provided producers with additional risk management flexibility. Instead. a new instrument is created, the regulated forward contract, which imposes upon farmers and merchants a new regulatory burden.
Page 136 PREV PAGE TOP OF DOC Segment 1 Of 4 The delivery requirement precludes producers from profiting from arbitrage opportunities which might exist during the life of the option. Therefore, the producer is denied the opportunity to settle out or to buy back the contract and resell the cash commodity to a better market The following example illustrates how this restriction imposes an economic penalty on a producer
The producer purchases put protection at $6 to grow soybeans. At planting time the price of beans drops from $6 to $5 a bushel while the price of cotton rises to 80 cents per pound. The producer is prohibited from selling his bean contract along with its $1 per bushel profit. He also lacks the right to plant cotton and secure even larger profits at 80 cents per pound given he is precluded from abandoning his profitable put protection contract on beans.
Restriction on Cash Settlements - In requiring physical delivery of the underlying agricultural product, the Commission failed to explain or adequately justify its prohibiting cash settlements
Regulation of Cash Cotton Market - Equally offensive is the requirement that a self-regulatory adjunct of the futures industry become the designated regulator of the cash markets.
Cash Market Participants - We encourage the Commission to clarify and liberalize the restrictions on access by allowing financial institutions and other responsible parties to facilitate the use of these new products through the availability of their financial resources.
Prohibition of Covered Calls - This restriction presumes that producers are not capable of determining, what types of trades are appropriate when a profit exists in a transaction and do not have the sense to capitalize on such situations to their benefit. The Commission should not presuppose that it can determine the appropriate risk parameters of all market participants.
Page 137 PREV PAGE TOP OF DOC Segment 1 Of 4 Restriction on Position Offset Prior to Termination - This proposal is risk management adverse in that a contract participant would be prohibited from locking in a favorable price or recouping the remaining time premium when the option position is no longer wanted or needed. In a situation where a producer has a $6 put on beans and the cash price rises to $8, he/she would want to sell in the cash market. In such a case. why should the producer be denied the right to sell the option and recoup the remaining time premium?
No other risk management tool denies the engaging parties from seeking a negotiated end to a contract. The Commission trusts the parties to negotiate the front end of a contract, but it does not trust the parties to negotiate their way out of a contract.
Market Risks - In establishing a viable Pilot Program in the trade of off-exchange trade options, the Commission must keep in mind that all of the risks identified by the Commission, fraud. credit, liquidity. operational, systemic. and legal, are the same risks inherent in forward contracts, which are exempt from regulation. Experience has demonstrated that the Uniform Commercial Code and the court systems of the various States afford adequate protection to the contracting parties. Uniform contract provisions, enforceable trade rules, and the availability of arbitration fora in the sale of agricultural commodities provides adequate protection for the contracting parities
We regret that we cannot be present for the meeting of the Advisory Committee given our long standing commitments. Should you or your staff have any questions regarding our position on these issues we will be happy to make ourselves available to discuss them with you. We also request that you share our views with the members of the Advisory Committee.
NEAL P. GILLEN
Executive Vice-President and General Counsel
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Statement of the FCM Coalition for Regulatory Fairness
The FCM Coalition for Regulatory Fairness is comprised of registered futures commission merchant), that is clearing firms that carry farmer and other customer accounts introduced by small, independent introducing broker. The Coalition is comprised of a group of commodity futures brokerage firms that collectively carry accounts for a majority of all guaranteed introducing brokers in the commodity futures industry. The Coalition*s members include: E.D.&F. Man International, Inc.; Farmers Commodities Corporation; First American Discount Corp.; Iowa Grain Company; LFG, LLC; REFCO Inc.; R.J. O*Brien & Associates, Inc.; Rosenthal Collins Group, LP; and Vision LP.
The Coalition appreciates this opportunity to provide a written statement to the House Committee on Agriculture in connection with its initial hearings on reauthorization of the Commodity Futures Trading Commission
The Coalition's FCM-members and the IBs for whom they carry accounts play a key role in providing farmers and other commercial businesses with access to and education about exchange-traded risk management instruments to hedge crop production and price risks. The Coalition is concerned that the CFTC and the National Futures Association have imposed rules, decisions and policies that inappropriately seek to hold FCMs strictly liable for the conduct of IBs solely because the FCMs guarantee the IBs' required minimum net capital.
Because many IBs are small businesses, they do not have the minimum capital required by CFTC regulations. As an alternative to satisfying the CFTC's capital requirement, an IB may enter a guarantee agreement with an FCM. However, the CFTC's required form of guarantee agreement, which was issued without prior notice or industry comment, purports to hold FCMs jointly and severally liable for the regulatory obligations and conductin addition to the required minimum capitalizationof their guaranteed IBs (GIBs).
Page 139 PREV PAGE TOP OF DOC Segment 1 Of 4 These regulatory actions are inconsistent with congressional intent in creating the introducing broker registration category and ultimately threaten the continued viability of the business relationship between FCMs and IBs. Access for farmers and other local and small businesses to exchange-traded risk management products will be reduced if fewer local IBs are available to assist producers and other small businesses in developing and implementing risk management strategies.
The CFTC/NFA approach has dramatically increased the regulatory risks faced by FCMs.
The number of FCMs who are willing to guarantee IBs is shrinking.
This situation threatens the existence of smaller IBs when industry needs them most.
The Coalition respectfully requests that the House Agriculture Committee address these concerns in considering the reauthorization of the CFTC. To help ensure the continued viability of IBs, the FCM Coalition has proposed an amendment to the Commodity Exchange Act, set forth at Exhibit A, for the committee's consideration. The amendment would permit FCMs to guarantee the payment obligations of IBs to a customer in an amount not in excess of the IB's required minimum net capital, without subjecting FCMs to unlimited strict liability for the regulatory violations and other misconduct of GIBs.
In addition, the FCM Coalition has proposed that the NFA enact a new Compliance Rule, which would require that clearing agreements specify, and FCMs notify customers of, the respective responsibilities and liabilities of FCMs and GIBs. The proposed NFA Compliance Rule also would require FCMs to provide the NFA with copies of all written customer complaints about GIBs. The proposed rule is similar to the pending proposed amendments to NASD Rule 3230, which governs clearing agreements between securities broker dealers and introducing brokers. The Coalition further proposes that the regulators adopt a ''safe harbor'' from regulatory liability for FCMs that provide traditional ''back office'' services to IBs and that supervise GIBs in accordance with NFA rules.
Page 140 PREV PAGE TOP OF DOC Segment 1 Of 4 The FCM Coalition's proposals strike an appropriate balance between protecting customers and ensuring that registrants comply with their regulatory responsibilities, and maintaining the viability of IBs as independent businesses to assist local producers and other participants in the futures markets.
The FCM Coalition has had preliminary discussions with Commission staff and NFA senior officials concerning these proposals for the FCM/GIB relationships, and has offered to work with the CFTC, NFA and the IB/GIB community to develop model best practices for the relationship between FCMs and GIBs.
II. INDUSTRY BACKGROUND
Introducing brokers play an important role in the commodity futures ndustry. IBs assist farmers and small businesses with customized risk management programs, educate them about using the futures markets to hedge price risk, and provide individual traders with incidental trading advice. These personalized services are increasingly important as farmers are encouraged to seek private sector tools (rather than Federal assistance programs) to manage price and production risks, and as the futures industry moves to electronic trading.
Before 1982, unregulated independent operators in agricultural communities in the heartland of America serviced individual traders of commodity futures contracts. These traders, many of whom were farmers, were reluctant to deal with a big-city brokerage firm in Chicago or New York. They preferred to do business with a local broker who knew the risks faced by local traders and understood the relationship between cash and futures prices.
In 1982, Congress amended the Commodity Exchange Act to create the IB registration category. Congress gave these unregulated local operators a choice of becoming an associated person (AP) or branch office of an FCM, or registering as an IB. Because local brokers wanted to remain independent, and FCMs lacked actual control over their operations, most of these local brokers decided to register as IBs instead of becoming APs or branch offices of an FCM.
Page 141 PREV PAGE TOP OF DOC Segment 1 Of 4 For most IBs it is too burdensome and expensive to register with the CFTC and NFA as non-guaranteed IBs. Many IBs operate as sole proprietorships, have only a few employees or service only a handful of accounts at any given time. Others employ a substantial number of APs. In either case, the CFTC's and NFA's net capital and record-keeping requirements act as barriers to registration in an independent capacity. For example, Section 7 of NFA's Financial Requirements mandates that independent IBs must maintain adjusted net capital equal to the greater of: (a) $30,000; (b) $6,000 per office; or (c) $3,000 for each AP. Thus, an independent IB with twenty APs must maintain adjusted net capital of at least $60,000. Moreover, the substantial expense for a certified annual audit, which typically costs $5,000 or more, is a significant deterrent to registration. As a result, the majority of IBs elect to be guaranteed by FCMs.
A. The IB's Important Role In The Commodity Futures Industry.
Since 1982, the role of the IB has evolved from doing business locally to servicing customers nationwide. Nevertheless, IBs continue to play an integral role in providing educational and risk management services targeted to farmers, small businesses, and individual traders:
Education. One of the most important services IBs provide remains educating individual traders about the futures markets through seminars, newsletters, and personal communications. IBs work with small groups and individuals to teach them how to use the futures markets. Although FCMs and exchanges provide some educational services, they generally do not reach the more remote locations and smaller customer groups like IBs. IBs reach thousands of individual investors and traders annually through in-person, print, and electronic educational presentations for agricultural producers, small businesses, and speculators.
Risk Management. IBs assist producers and commercial entities in determining which risk management tools to use, and how and when to use them. Many local IBs personally visit farmers to explain how options and futures fit with crop insurance, forward contracting, and Government programs to help manage the costs and risks of their businesses. The IB often helps develop a customized risk management plan for clients. Then, the IB places the customer's orders for hedge positions.
Page 142 PREV PAGE TOP OF DOC Segment 1 Of 4 Market Liquidity and Price Discovery. A large percentage of the IB community places orders for smaller quantities (i.e., one-lot and five-lot orders) compared to the large orders often placed directly through FCMs. The smaller trades enhance market liquidity and price discovery for futures and options, especially in the agricultural markets.
These services will continue to be important even as futures intermediary services increasingly become computerized. If IBs are allowed to continue to operate independently, they will continue to enhance the trading decisions of individual traders and assist farmers and other businesses with risk management.
B. The Relationship Between FCMs And IBs.
GIBs rely on FCMs for capitalization, maintaining customer funds, providing customer agreement forms and account statements, and other ''back office'' services in exchange for introducing customer accounts and providing customer service. The entrepreneurs who operate IBs consider themselves to be independent and have a strong desire to run their own small business. These independent firms are not agents or branch offices of the FCM. Indeed, it is more accurate to view the IB, which is chosen by the customer, as the customer's agentnot as an agent of the FCM.
Like broker-dealers in the securities industry, FCMs receive compensation for providing clearing services to the IB. Although FCMs benefit from the collective volume of business they receive from doing business with many introducing firms, the amount of business generated by any one IB does not justify the cost of either supervising each firm as though it were a branch office of the FCM or assuming liability for all of the IB's activities.
Despite the independent business relationship between FCMs and GIBs, recent decisions by the CFTC and NFA impose strict liability on the FCM for the acts of GIBs, and fail to acknowledge the many distinctions between a guaranteed IB and a branch office of an FCM. The effect of these decisions has been to reduce substantially the number of FCMs who are willing to guarantee IBs. Currently, only about fifteen FCMs guarantee at least five IBs. See NFA FCM Guarantor Directory (as of Feb. 28, 1998). The NFA Directory lists about 31 FCMs (out of 232 FCMs registered in February 1998), who guarantee IBs. Only fifteen of these FCMs guarantee five or more IBs; the remaining sixteen FCMs guarantee only four or fewer IBs.
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With fewer FCMs willing to guarantee IBs, the financial and regulatory risks created by the CFTC-mandated Guarantee Agreement have become concentrated in a diminishing pool of clearing firms. Without changes in the law, it soon may be that no FCM will be willing to guarantee IBs and there no longer will be small independent firms available to provide personal service to farmers and other users of the commodity futures and options markets.
III. LEGISLATIVE BACKGROUND
A. The Commodity Exchange Act Does Not Authorize The CFTC To Impose Strict Liability On FCMs For The Acts Of GIBs Based On A Guarantee Agreement.
The Coalition respectfully submits that the CFTC's and NFA's regulatory treatment of the relationship between FCMs and GIBs over the past 16 years has ignored Congress's intent in 1982 when it created the IB registration category. The Commodity Exchange Act does not make GIBs agents of FCMs. Although the CEA contains several provisions imposing secondary liability in appropriate circumstances, none of those provisions makes a guarantor FCM vicariously liable for acts of its GIBs without a showing of facts demonstrating an agency relationship or another basis for imposing secondary liability. E.g., CEA 2(a)(1)(A)(iii), 7 U.S.C. 4 (subjecting principals to liability for the wrongful acts of their agents who are acting within the scope of their agency); CEA 13(a), 7 U.S.C. 13c(a) (imposing liability for aiding and abetting); CEA 13(b), 7 U.S.C. 13c(b) (imposing liability upon *controlling persons* for the acts of persons they control).
B. The Legislative History Of The Futures Trading Act Of 1982 Shows That Congress Rejected The CFTC's Proposal To Impose Strict Liability On FCMs For The Acts Of Independent Introducing Brokers.
The legislative history of the Futures Trading Act of 1982 (the 1982 FTA), Pub. L. No. 97-444, 96 Stat. 2294 (1983).
Page 144 PREV PAGE TOP OF DOC Segment 1 Of 4 which created the introducing broker registration category, shows that Congress did not intend that FCMs automatically would assume strict liability for the acts of individuals and entities required to register as introducing brokers under the new legislation.
Before enactment of the 1982 FTA, several CFTC cases had used CEA 2(a)(1) and theories of principal/agent liability to hold FCMs strictly liable for the conduct of independent, unregistered agents who solicited orders and introduced customer accounts to FCMs. E.g., Perkins v. First London Commodity Ltd., [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) 20,659 (Init. Aug. 15, 1978) (holding an FCM liable for an *agent*s* fraud and misappropriation of customer funds, despite the fact that the FCM never participated in the fraud); Anderholt v. Rosenthal & Company, [1977-1980 Transfer Binder] Comm. Fut. L. Rep. (CCH) 21,218 (Init. Jun. 26, 1981) (imposing liability on an FCM for the unauthorized trading of an independent contractor *agent*).
During the 1982 CFTC reauthorization process, there was a general consensus among the industry and the CFTC that Congress should address the lack of regulatory status for these unregistered agents, although there was no consensus regarding how to fill the regulatory gap. See generally Don L. Horwitz & David J. Gilberg, Introducing Brokers Under the Commodity Exchange Act: A New Category of Commodity Professionals, 40 Wash. & Lee L. Rev. 907, 918-22 (1983) (describing the legislative history leading to the enactment of the *introducing broker* registration category).
The CFTC recommended requiring each ''agent'' to register as an AP of an FCM. S. Rep. No. 384, 97th Cong., 2d Sess. 40 (1982) (*Senate Rep.*); CFTC Reauthorization: Hearings Before the Subcomm. on Conservation, Credit, and Rural Dev. of the House Comm. on Agriculture on H.R. 5447, 97th Cong., 2d Sess. 120, 122 (*House Hearings*) (statement of Philip McB. Johnson, CFTC Chairman).
The CFTC's proposal was supposed to ''create a parity of responsibility between futures commission merchants using associated person [sic] at branch offices and those using agents as sales representatives.'' Id.
Page 145 PREV PAGE TOP OF DOC Segment 1 Of 4 The CFTC testified: ''Thus, the [FCM] would be responsible for its agents to the same extent as for its branch offices.'' House Hearings at 122 (statement of Philip McB. Johnson, CFTC Chairman). Accord Hearings on S. 2109 before the Subcomm. on Agriculture, Research and General Legislation of the Senate Comm. on Agriculture, Nutrition and Forestry, 97th Cong., 2d Sess. 5 (1982) (*Senate Hearings*).
In contrast to the CFTC, Representatives of the futures industry and the Committee on Commodities Regulation of the American Bar Association, proposed the creation of a separate registration category for ''introducing brokers,'' who would be neither agents nor APs. Industry representatives testified that these agents merely use the FCM's services for clearing, recordkeeping, and safeguarding of funds. Because the agents are not closely tied to the FCM and often move from FCM to FCM, the FCM cannot effectively control the agent's activities. Senate Rep. at 41.
The ABA Committee stated that the agents should be required to ''stand on their own and be directly responsible for meeting their obligations.'' Id. The ABA Committee elaborated in testimony:
The problem with the CFTC approach is that [*agents*] are for the most part independent firms and proprietorships scattered throughout the country. In most cases, the futures commission merchants with whom they do business cannot exercise anything like the same control over the [*agents*] as they can over their own employees. The theory of the [ABA] Draft is that these businesses should stand on their own feet from a regulatory point of view and be directly responsible for meeting their obligations. Of course, if in any case an agency relationship can be shown to exist, then a futures commission merchant could be held liable for the acts or omissions of the [*agents*] under traditional agency concepts.
Page 146 PREV PAGE TOP OF DOC Segment 1 Of 4 House Hearings at 546 (statement of Edmund R. Schroeder, Chairman, ABA Committee on Commodities Regulation).
The ABA Committee recommended that IBs be subject to the same types of regulatory requirements as FCMs, but advocated an exemption for IBs from the CFTC's segregation requirements (since IBs do not handle customer funds). Senate Hearings at 542-43; House Hearings at 544-45 (cited in D. Horwitz & D. Gilberg, supra note 9, at 920).
The CFTC and some House Members argued against the industry proposal, claiming that the FCMs would be insulated from liability for acts committed by IBs. Philip McB. Johnson, then CFTC Chairman, testified that the approach sought by industry and the ABA would make IBs independent contractors, so that no liability could be imputed to the FCMs. Chairman Johnson further argued that if IBs were registered as APs, the FCMs would be responsible for the IBs as if they were operating a branch office of the FCM. H.R. Rep. No. 565(I) at 133 (1982), reprinted in 1982 U.S.C.C.A.N. 3871, 3982 (*House Rep.*).
This discussion makes it clear that, in deciding whether to require agents to register as APs or IBs, Congress understood that it also was deciding whether to impose vicarious liability on FCMs for the acts of agents. Initially, the House Subcommittee on Conservation, Credit & Rural Development of the House Agriculture Committee adopted the CFTC proposal to require *agents* to register as APs of FCMs. The House Report describes the exchange that preceded the House subcommittee vote on the CFTC proposal:
[Congressman] Glickman stated that if the Subcommittee decided to create an *introducing broker* category as requested by industry the effect might be to insulate a [FCM] from liability for acts committed by the introducing brokers. ... [This] might not be in the public interest.
Page 147 PREV PAGE TOP OF DOC Segment 1 Of 4 [CFTC Chairman] Johnson agreed ... add[ing] that the introducing broker approach requested by industry would make the agent an independent contractor. As an independent contractor an agent would be liable for his own acts. Under the CFTC approach of registering agents as [APs], the futures commission merchant would be responsible as if the agent were operating as a branch office employee. Mr. Glickman moved the CFTC amendment, and it was unanimously adopted by voice vote.
House Rep. at 133.
Requiring agents to register as APs of FCMs imposed vicarious liability on FCMs, while requiring agents to register as IBs would make independent IBs solely liable for their own acts.
Ultimately, both the House and Senate Agriculture Committees rejected the CFTC approach and adopted the regulatory scheme recommended by the ABA Committee and the futures industry to establish a new category of ''introducing broker.'' At that time, the Senate Agriculture Committee explained that it adopted the ABA/industry proposal because:
[A] significant number of the agents of futures commission merchants are, in fact, independent business entities that utilize the services of futures commission merchants for clearing, and recordkeeping functions and for the safeguarding of investors' funds. In such cases, it is difficult to envision how the futures commission merchant could exert the kind of control mandated in the Commission's proposal.
In light of these facts, the committee felt it would be inappropriate to (1) require these independent business entities to become branch offices of the futures commission merchants through which their trades are cleared or (2) to impose vicarious liability on a futures commission merchant for the actions of an independent entity. The committee notes that there are a number of existing legal theories that the Commission may employ to hold a futures commission merchant liable for the acts of an ''introducing broker'', if, in fact, the ''introducing broker'' is not independent but is operating as a de facto branch office of the futures commission merchant. Senate Rep. at 41 (some emphasis added).
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The Conference Report also evidences Congress's deliberate decision to create a new class of registrant to include persons who solicit funds but elect not to register as APs of an FCM. H.R. Conf. Rep. 964, 97th Cong., 2d Sess. 41 (1982), reprinted in 1982 U.S.C.C.A.N. 4055, 4059 (*Conf. Rep.*).
There is no evidence that Congress intended to impose strict liability on FCMs for the conduct of IBs.
The 1982 FTA amended the CEA to require all individuals who solicit public orders and meet the definition of ''introducing broker'' to register with the CFTC (unless they are exempt or have registered as APs of an FCM). Id.; 1982 FTA 207-08, 96 Stat. at 2302 (codified at CEA 4d, 4f).
The FTA defined an ''introducing broker'' as:
any person, except an individual who elects to be and is registered as an associated person of a futures commission merchant, engaged in soliciting or in accepting orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any contract market who does not accept money, securities, or property to . . . secure any trades or contracts that result or may result therefrom. Id. 201, 96 Stat. at 2297 (currently codified at CEA 1a (14)).
In addition, the FTA amended CEA 4f, authorizing the CFTC to establish, as necessary, minimum financial requirements to ensure that IBs, like FCMs, meet their obligations as registrants. Id. 208, 96 Stat. at 2302.
The CEA, as amended, now provides:
Notwithstanding any other provision of this Act, no person desiring to register as futures commission merchant or as introducing broker shall be so registered unless he meets such minimum financial requirements as the Commission may by regulation prescribe as necessary to insure his meeting his obligation as a registrant, and each person so registered shall at all times continue to meet such prescribed minimum financial requirements: Provided, That such minimum financial requirements will be considered met if the applicant for registration or registrant is a member of a contract market and conforms to minimum financial standards and related reporting requirements set by such contract market in its bylaws, rules, regulations or resolutions and approved by the Commission as adequate to effectuate the purposes of this subsection. CEA 4f(b) (emphasis added).
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In authorizing the CFTC to issue rules regarding the minimum capital requirements for the new category of registrant, or ''IBs'' the Conference Committee stated:
''Because many introducing brokers will be small businesses or individuals, as contemplated by the definition of this class of registrant, the conferees contemplate that the Commission will establish financial requirements which will enable this new class of registrant to remain economically viable, although it is intended that fitness tests comparable to those required by associated persons will be employed. The intent of the conferees is to require Commission registration of all persons dealing with the public, but to provide the registrants with substantial flexibility as to the manner and classification of registration.'' Conf. Rep. at 41, 1982 U.S.C.C.A.N. at 4059 (emphasis added).
In sum, the legislative reports prepared contemporaneously with Congress's consideration and passage of the 1982 FTA demonstrate that Congress expressly rejected any notion that IBs be treated the same as APs operating from a branch office, or that FCMs automatically be held strictly liable for the conduct of independent IBs as if they were agents. Instead, Congress indicated that the CFTC may employ existing legal theories to hold an FCM liable for the acts of an IB that is not independent, but is operating as a de facto branch office of the FCM. E.g., Senate Rep. at 41.
The legislative history also shows that, while Congress directed the CFTC to require registration of IBs, Congress required the CFTC to establish flexible financial standards which would permit small IBs to remain economically viable.
IV. CFTC REGULATORY HISTORY
A. History Of The Required Guarantee Agreement For Introducing Brokers.
In April 1983, the CFTC proposed rules to implement the 1982 FTA and govern the new IB and other registration categories. CFTC, Notice of Proposed Rules, Introducing Brokers and Associated Persons of Introducing Brokers, Commodity Trading Advisors, and Commodity Pool Operators; Registration and Other Regulatory Requirements, 48 Fed. Reg. 14,933 (Apr. 6, 1983). The Commission proposed rules and rule amendments to: establish registration requirements and procedures for the new categories of registrants; prescribe minimum financial, reporting and recordkeeping requirements of IBs; create certain exemptions from registration; and specify appropriate regulatory responsibilities for IBs and other registrants. 48 Fed. Reg. at 14,933.
Page 150 PREV PAGE TOP OF DOC Segment 1 Of 4 There, the CFTC proposed that IBs use Form 1-FR for their financial reporting. The CFTC noted that the changes to the form necessitated by the proposed amendments were not being published ''because those changes are of a minor, technical nature and because form 1-FR does not appear in the Code of Federal Regulations.'' Id. at 14,947, 14,948 & n.90 (emphasis added).
Four months later, the CFTC adopted lengthy final rules setting forth the registration requirements and procedures for IBs. CFTC, Final Rules, 48 Fed. Reg. 35,248 (Aug. 3, 1983).
At the suggestion of some commenters, the CFTC allowed any IB which is a party to a ''Guarantee Agreement,'' as defined in a new CFTC Rule 1.3(nn) and set forth in Part B of Form 1-FR, to satisfy its capital requirement solely by entering into the Guarantee Agreement. Id. at 35,249 (codified at 17 C.F.R. 1.17(a)(2)(ii)).
The CFTC explained:
In essence, the Guarantee Agreement provides that the FCM which is a party to the agreement will guarantee performance by the [IB] of its obligations under the act and the rules, regulations, and order [sic] thereunder. As such, the guarantee agreement is an alternative means for an [IB] to satisfy the Commission's standards of financial responsibility for its activities as an introducing broker. Id. (emphasis added).
In adopting these rules permitting the use of a Guarantee Agreement as an alternative minimum capital mechanism for IBs, the CFTC added that:
''[The] alternative adjusted net capital requirement embodied in the guarantee agreement is consistent with two of the factors upon which an adjusted net capital requirement for IBs should be based: (1)insuring that IBs are not judgment proof; and (2)providing coverage for potential liabilities of IBs arising from business operations and customer relations.'' Id. at 35,264.
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The CFTC reprinted the requisite Guarantee Agreement, appended as a new Part B to Form 1-FR, at the back of the final rules. Contrary to the CFTC's statement that the purpose of the Guarantee Agreement is to make sure that IBs meet their ''financial responsibility'' under the CEA, the Guarantee Agreement purports to make guarantor FCMs responsible for ''all obligations'' of an IB under the CEA. The Guarantee Agreement provides, in pertinent part:
In consideration for the introduction of customer and option customer accounts by an introducing broker, to a futures commission merchant registered with the Commission as such, and in satisfaction of the adjusted net capital requirements with which the introducing broker otherwise would have to comply pursuant to Commission Regulation 1.17, 17 CFR 1.17, the futures commission merchant guarantees performance by the introducing broker of, and shall be jointly and severally liable for, all obligations of the introducing broker under the Commodity Exchange Act, as it may be amended from time to time, and the rules, regulations and orders which have been or may be promulgated thereunder with respect to the solicitation of and transactions involving all customer and option customer accounts of the introducing broker entered into on or after the effective date of this agreement. Id. at 35,305 (emphasis added).
The Guarantee Agreement is not included in the Code of Federal Regulations.
B. The CFTC's Imposition Of Liability Upon FCMs For The Acts Of GIBs Through The Guarantee Agreement Is Contrary To Congressional Intent.
The CFTC's required form of Guarantee Agreement, while purportedly created as an alternative means to meet the net capital requirements for IBs, also imposed joint and several liability on the guarantor FCM for all obligations of the IB under the actin direct contravention of the congressional intent of the 1982 FTA. In effect, the CFTC included in the form of a Guarantee Agreement the same strict joint and several liability concepts that Congress expressly rejected. Under the guise of an ''alternative'' to the net capital requirement, the CFTC ushered in a wolf in sheep's clothing and effectively circumvented Congress's stated intent to regulate introducing brokers without automatically imputing liability to the FCMs to whom they refer accounts. The Guarantee Agreement, in practice, is not just ''an alternative means for an IB to satisfy the CFTC's standards of financial responsibility,but rather an alternative means for the CFTC to resurrect the strict liability concept that Congress explicitly declined to adopt.
Page 152 PREV PAGE TOP OF DOC Segment 1 Of 4 The CFTC's actions also frustrate Congress's intent that IBs remain independent and economically viable. As noted above, in creating the new registration category for IBs, Congress authorized the CFTC to issue regulations consistent with the following guidelines:
Congress contemplated that the CFTC would establish financial requirements which would enable this new class of registrant to remain economically viable;
Congress intended that the CFTC would provide IBs with substantial flexibility as to the manner and classification of registration; and Congress felt it would be inappropriate to require these independent business entities to become branch offices of the FCMs through which their trades are cleared. Conf. Rep. at 41, 1982 U.S.C.C.A.N. at 4059; Senate Rep. at 41.
Notwithstanding Congress's dictates for financial requirements that would sustain the economic viability of IBs and for ''substantial flexibility'' in other regulatory requirements, the CFTC and NFA rules regarding minimum capital requirements and other reporting and compliance obligations are so burdensome that they effectively require many IBs to enter into Guarantee Agreements with FCMs; consequently, the CFTC and NFA treat GIBs as if they were de facto branch offices of the guarantor FCMs. This result effectively circumvents congressional intent in creating the IB registration category.
Although the CFTC and NFA rules on their face do not require FCMs and IBs to enter into Guarantee Agreements, the financial and regulatory barriers they establish preclude any meaningful choice for many IBs. Nearly 75 percent of IBs have determined that a Guarantee Agreement is a more viable (or the only viable) alternative to meeting the high financial and regulatory requirements. Congress anticipated a vibrant new category of independent IBs who were neither agents nor branch offices of FCMs. The minimal number of independent IBs and the limited number of FCMs that are willing to guarantee the remaining IBs (whom regulators improperly view as de facto branch offices) indicate that Congress's intent has not been fulfilled.
Page 153 PREV PAGE TOP OF DOC Segment 1 Of 4 C. The CFTC Adopted The Guarantee Agreement For IBs Without Adequate Notice And Comment, In Violation Of The Administrative Procedure Act And The CFTC's Public Rulemaking Procedures.
Pursuant to the Administrative Procedure Act agencies may adopt regulations only after reasonable public notice and opportunity for comment by interested persons. 5 U.S.C. 553; accord 17 C.F.R. Part 13.
Although a final rule need not be identical to the original proposed rule, ''[i]f the final rule deviates too sharply from the proposal, affected parties will be deprived of notice and opportunity to respond to the proposal.'' AFL-CIO v. Donovan, 757 F.2d 330, 338 (D.C. Cir. 1985) (citation omitted); accord Chocolate Mfrs. Assoc. v. Block, 775 F.2d 1098, 1104 (4th Cir. 1985) (*An interested party must have been alerted by the notice to the possibility of the changes eventually adopted from the comments.*).
In deciding whether a second round of comment is required before the agency issues a final rule differing from the proposed rule based on comments received during the first round of comment, the courts look to see whether the final rule promulgated by the agency is ''a logical outgrowth'' of the original proposed rule. American Water Works Ass*n v. EPA, 40 F.3d 1266, 1274 (D.C. Cir. 1994); AFL-CIO, 757 F.2d at 338; Chocolate Mfrs., 755 F.2d at 1105 (citing cases from several circuits).
There is no ''logical outgrowth'' if the final rule materially alters the issues involved in the rulemaking or substantially departs from the terms or substance of the proposed rule. Id.
Here, the CFTC's initial notice stated that it proposed rules, which would establish registration requirements for IBs, prescribe minimum financial, reporting and recordkeeping requirements, create certain registration exemptions, and specify appropriate regulatory responsibilities for IBs. 48 Fed. Reg. at 14,933.
Page 154 PREV PAGE TOP OF DOC Segment 1 Of 4 The CFTC's notice further stated that any modifications to Form 1-FR were of a ''minor, technical nature.'' Id. at 14,948 n.90.
The CFTC did not publish for comment either the regulations setting forth the alternative to meeting the net capital requirements for IBs by operating pursuant to a Guarantee Agreement or the corresponding Guarantee Agreement. Rather, the CFTC promulgated the regulations and Guarantee Agreement after publishing proposed rules for IBs *at the suggestion of some of the commentators.* Id. at 35,249.
The regulations specifying a Guarantee Agreement for IBs and the required form of Guarantee Agreement deviated sharply from and were not a logical outgrowth of the CFTC's initial proposed rules. The final rule and the Guarantee Agreement should have been published for a second round of comments, so that FCMs and other industry participants would have an opportunity to respond to the proposal. Accordingly, the CFTC's required form of Guarantee Agreement and related rules are invalid and should be amended because they were adopted with virtually no notice, much less adequate notice, in violation of APA 553. AFL-CIO, 757 F.2d at 338, 340.
The CFTC, however, recently rejected an APA-based challenge to the integrity of the 1983 rulemaking proceedings leading to the adoption of the Guarantee Agreement. Violette v. First American Discount Corp., CFTC Dkt. No. 97-R020, Order at 4-5 (Feb. 24, 1999).
The Coalition's legislative proposal to amend Section 4f(b) of the Commodity Exchange Act, 7 U.S.C. 6f(b) would permit FCMs to guarantee the payment obligations of IBs to a customer in an amount up to the IB's required minimum net capital, without subjecting FCMs to unlimited strict liability for their guaranteed IBs' regulatory violations and other conduct. The Coalition's proposed amendment would cap FCMs' liability for GIBs and thus help secure the viability of IBs as independent businesses. This proposal strikes an appropriate balance between protecting customers and ensuring that registrants comply with their regulatory responsibilities, and maintaining the viability of IBs as independent businesses to assist local producers and other participants in the futures markets.
Page 155 PREV PAGE TOP OF DOC Segment 1 Of 4 The Coalition's legislative proposal would implement Congress's clearly stated goal of promoting the development and availability of independent providers of risk management services to farmers and small businesses. The Coalition's legislative proposal, as well as its proposals for a new NFA Compliance Rule and ''safe harbor,'' are timely and necessary in today's increasingly competitive and rapidly changing business environment, to ensure that commodity futures intermediaries remain viable and available to help end-users understand and manage their risks. Accordingly, the Coalition respectfully requests that, as the House Agriculture Committee addresses the reauthorization of the CFTC, the committee enact the Coalition's legislative proposal and direct the implementation of the Coalition's additional regulatory measures.
The Coalition and its counsel are available at the convenience of the committee and committee staff to discuss the Coalition's proposal in more detail.
Proposed Amendment to Section 4f(b) of the Commodity Exchange Act, 7 U.S.C. 6f(b)
The Coalition proposes the following amendment to Section 4f(b) of the Commodity Exchange Act, 7 U.S.C. 6f(b)
(b) Notwithstanding any other provisions of this Act, no person desiring to register as futures commission merchant or as introducing broker shall be so registered unless he meets such minimum financial requirements as the Commission may by regulation prescribe as necessary to insure his meeting his obligations as a registrant, and each person so registered shall at all times continue to meet such prescribed minimum financial requirements: Provided, That such minimum financial requirements will be considered met if the applicant for registration or registrant is a member of a contract market and conforms to minimum financial standards and related reporting requirements set by such contract market in its bylaws, rules, regulations, or resolutions and approved by the Commission as adequate to effectuate the purposes of this subsection; and Provided further, That, in the case of an introducing broker, such minimum financial requirements will be considered satisfied if a futures commission merchant agrees to guarantee the introducing broker's payment obligations in an amount equal to the minimum financial obligations prescribed by the Commission. Notwithstanding the foregoing, a futures commission merchant's agreement to guarantee an introducing broker's minimum financial requirements shall not impose liability upon the futures commission merchant for all other obligations of the introducing broker under the Commodity Exchange Act, as it may be amended from time to time, or the rules, regulations and orders that have been or may promulgated thereunder.
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Statement of the National Introducing Brokers Association
Thank you for requesting the opinion of the National Introducing Brokers Association (NIBA), on the very important issue of Reauthorization of the Commodity Futures Trading Commission (CFTC), which is now before your committee.
The NIBA is a not-for-profit organization of professional futures and options brokers, incorporated in 1991. Both guaranteed and independent introducing brokers (IBs)are represented, in addition to five commodity exchanges and seven futures commission merchants. Our purposes are: to insure and promote the existence of the IB; to voice the opinion of the membership with regard to issues which specifically impact the business of IBs; and, to encourage good business practices within the industry.
Our membership includes introducing brokers whose primary businesses focus on price and risk management programs for the farming community, as well as those who specialize in the financial, metal, energy and other commodity markets, Many of our members offer crop insurance, buy and sell cash products such as grain, livestock or natural gas, or broker stocks, bonds and mutual funds. All of our members are required to pass a national examination, be licensed, periodically undergo ethics training, be registered by the CFTC and by the National Futures Association (NFA), and are subject to frequent audits by regulators from the two above mentioned agencies as well as from brokerage houses and exchanges.
The NIBA supports the reauthorization of the CFTC. The Commission is the best regulatory agency to exercise authority, and to have enforcement powers over futures and options transactions and industry participants. However, we wish to comment on several specific topics having to do with this endeavor.
(1) Congress must clearly define the duties and responsibilities of the CFTC, and insure it has sufficient funding and authority to do the job.
Page 157 PREV PAGE TOP OF DOC Segment 1 Of 4 An example of the Commission's failure to act rapidly because of lack of clarity occurred during the confusion over ''hedge-to-arrive'' grain contracts. The CFTC apparently did not know if these contracts fell within the definition of ''futures,'' and consequently, were subject to their jurisdiction. This confusion is bound to reoccur as new uses for futures and options contracts are devised, if no clear product and jurisdictional definitions are promulgated by Congress.
Furthermore, the CFTC appears to be confused with regard to the regulation of ''agricultural trade options.'' At times during the NIBA's interactions with the Commission, the agency seems almost willing to completely relinquish regulation in this area in favor of allowing unregulated, unstandardized programs to be presented to the public by the very groups with the most to gain financially from the lack of regulation. This confusion will be eliminated if Congress clearly defines the duties and responsibilities of the agency.
Additionally, the CFTC is slow to act when an abuse is committed by a ''nonregistrant.'' The Commission apparently takes the position that an entity or person who is not registered with their agency and/or the NFA, can not be prevented from defrauding the public through deceptive sales practices, because the agency has no jurisdiction. This argument is analogous to allowing persons who drive automobiles without licenses and have accidents, to continue to drive because the licensing body has no authority over them. Obviously, this is ridiculous. Further, this will result in painting the ''good guys'' in the industry with the same brush as the bad, so that the entire futures and options business will suffer from poor public opinion.
The CFTC has stated in its Strategic Plan for the years 1997 through 2000, that it is doing the best it can with the financial and personnel resources it is allowed per Congressional decree. While the NIBA has no argument with that, we feel it is essential to review the responsibilities and duties of the CFTC, and bring its funding into line with all other regulatory bodies, if and where it is not. This must happen so that the Commission can attract and keep the best employees, can remain current with technological advances, and can provide the futures and options industry with the highest possible professional level of regulation.
Page 158 PREV PAGE TOP OF DOC Segment 1 Of 4 (2) Congress should review and revise where necessary, the role of the Commission to provide for a minimum of interference in the operation and improving of industry registrant's businesses.
It is the business of industry registrants, such as licensed exchanges to provide innovative, effective methods for using the marketplace to the public. It is the work of the Commission to see that these methods are in the best interest of the ultimate users. Therefore, daily business decisions such as delivery policies, professional market programs, and the development of new products, should be left to the industry itself. Generally, the exchanges will provide product and methods which are good. for all industry participants, including IBs and their customers.
Additionally, it is worth noting that the CFTC, working with the NFA, has been very effective in cleaning out many of the ''bad guy'' IBs and commodity trading advisors (CTAs) during the past few years. However, continuing to apply old standards or establishing new rules which have the effect of micro-managing an IB's or CTA's business, and may have long term adverse effects on that firm's ability to change and grow, is not the way to keep the bad guys from reemerging.
Congress should look at the CFTC with an eye to keeping the U.S. markets competitive and effective. Overburdensome daily surveillance, duplicity and excessive regulation should be eliminated from the duties of the Commission.
(3) Congress must be assured that the CFTC is responsive to the objectives of all industry participants by enacting policies and procedures which allow for better communication with registrants, and other market participants.
The NIBA recognizes that it is not possible to anticipate each event the Commission will be faced with in the coming years and the response necessary to deal adequately with those events. But we do know that in past years our organization has brought ''hot issues'' to the attention of the CFTC which were dealt with slowly, ineffectively, or not all. The NIBA believes that the CFTC should work more closely with industry participants when enacting policy or making major decisions.
Page 159 PREV PAGE TOP OF DOC Segment 1 Of 4 The public hearings held during the confusion over the ''trade option'' issue was a good example of the CFTC including the industry before policy decisions were made. But this type of communication is the exception, not the rule. More roundtable, public hearings or small discussions groups will assure that both the industry and the Commission understand changes or new issues; that those changes or issues are necessary and cost effective; and, that the registrants will implement any changes or offer new issues with regard to the necessary compliance standards. Everyonethe Commission, the registrant and the customerwill benefit.
The NIBA also wants to go on record as supporting better communication between regulatory agencies, namely the CFTC and the NFA. Coordination and cooperation would greatly enhance the efficiency of these organizations, thereby cutting down on essentially identical efforts, reducing costs and eliminating confusion.
Although not strictly within the reauthorization topic, the National Introducing Brokers Association has been asked to address certain issues currently being put forth by the ''FCM Coalition.'' The NIBA was asked to attend one meeting of the FCM Coalition, and we were asked to submit suggestions to that group. The FCM Coalition, as we understand it, is made up of futures commission merchants who are working together to bring change with regard to the CFTC imposed
NFA policies regarding liability of the FCM and the guaranteed introducing broker (GIB).
Please be aware of the importance of the GIB to the entire futures industry. Since the numbers of GIBs registered with the NFA outnumber independent IBs (IIBs) nearly three to one, it is reasonable to postulate that the industry itself would change if these brokers were forced to significantly change their business relationships, or were forced out of business entirely. (See NFA Registration Statistics.)No other registrant in the futures industry is performing these functions.
(1) Education. Education is the No. 1 function performed by many GIBs. Most FCMs do not hold seminars, give classes or work one-on-one with individual farmers or investors to explain the use of the futures markets. Although many exchanges do a limited amount of field work, it is economically infeasible for them to reach smaller or rural locations, or hold a meeting for as few as fifteen or twenty customers. GIBs do this routinely. Several NIBA members reach thousands of individuals annually, through in-person, print or electronic presentations to both producers and speculators.
Page 160 PREV PAGE TOP OF DOC Segment 1 Of 4 (2) Risk Management Plans. The local GIB is most frequently the person who makes an on-farm visit to explain how futures and options fit into a risk management plan. After assessing the producer's crop insurance coverage, cash forwarding, government programs, financial status and personal needs, the GIB will help develop a customized program to meet each individual's requirements. Often only the GIB among a professional group which may include a banker, insurance agent, elevator operator or farm manager, has the knowledge required to present the possible scenarios for pricing and marketing strategies, and actually place a hedge for risk management purposes.
(3) Liquidity and Necessary Price Discovery or Efficient Markets. Many GIBs place customer orders for smaller quantities of product than are placed through the FCM. Without those trades, liquidity will be diminished and price discovery will become more difficult. Additionally, many exchange members, particularly those who make their living in the agricultural pits, stand to lose a significant portion of their income if they do not process these trades.
(4) Assuming Business Risk. The GIB solicits the customer account, and therefore is responsible to ''know the customer.'' The IB ascertains the customer's ability to take financial risk, credit worthiness and the individual's investment goals. This has the effect of shifting some of the liability for customer actions, including debits, if any, to the IB. This is well within Congress 'original intent as evidenced by the record during the 1982 discussion of the registration category. Customers who have a limited knowledge of the markets, or need only hedging services, or wish to deposit a smaller amount, may not be welcome at the FCM without an IB to assume some portion of the business risk. This entire segment of the population could be denied the opportunity to participate in the markets.
From the above, it is clear that introducing brokers, particularly those who operate under the guarantee agreement of a brokerage house, play an essential and unique part in the futures industry -one which will not in all likelihood, be filled if the GIB is forced from the industry.
Page 161 PREV PAGE TOP OF DOC Segment 1 Of 4 The NIBA believes that developing a ''best practices'' guide or a ''standard'' which FCMs could agree upon to be used when contemplating a guaranteed relationship, might be, in part, a solution to the dilemma now under discussion by the FCM Coalition. Possible items to include when developing such a standard are:
(1) Requiring potential candidates for the guarantee agreement to submit to the FCM: (i) a business plan. (ii) a summary of the IB's risk management technique
(2) Setting a limit on the number of regulatory actions an IB can be involved in before disqualification for guaranteed status.
(3) Requiring the IB to spent a certain period of time in the FCMs home office becoming familiar with each department, its responsibilities and its personnel.
(4) Requiring that an audit be performed at the IB's offices by the FCM within the first three to four months of the business relationship, and every 6 months thereafter if significant non-compliance is found.
(5) Increasing the FCM's financial responsibility for each account, and incorporating language that explains each parties 'liability into the customer documentation.
Thank you for requesting the views of the National Introducing Brokers Association on these important issues regarding our regulatory agency, the Commodity Futures Trading Commission. It is essential that the interests of introducing brokers be represented during the discussions on reauthorization, and the policy decisions which will be made during that procedure. Please contact us at the above number and address anytime to provide additional information.
The NIBA is proud to be part of the process.
"The Official Committee record contains additional material here."
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