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REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION
THURSDAY, MAY 20, 1999
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to call, at 9:45 a.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Smith, Lucas of Oklahoma, Moran, Thune, Jenkins, Gutknecht, Walden, Hayes, Condit, Dooley, Pomeroy, Baldacci, Goode, Stabenow, Etheridge, John, Boswell, Lucas, and Stenholm [ex officio].
Staff present: Stacy Carey, subcommittee staff director; Ryan Weston, Greg Zerzan, John Riley, Callista Bisek, and Wanda Worsham, clerk.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. The meeting of the Subcommittee on Risk Management, Research, and Specialty Crops to review the Commodity Future Trade Commission reauthorization will come to order.
I want to welcome all those in the room and those on the committee back for our third day of hearings this week. It has been a little of a marathon, but I think our discussions thus far have been very productive and the procedure is working towards our announced goal.
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I look forward to today's discussion, which I suspect will largely focus on the Shad-Johnson Accord, Treasury amendment and legal certainty for swaps. I feel confident in saying I believe that there are three must-dos in our reauthorization process. One, we must provide regulatory relief to the U.S. futures exchanges. Two, we must provide legal certainty for the swaps market. And three, we must clarify the scope of the Treasury amendment. It is with those in mind and all of the other issues that are on the table here today that I welcome you and thank you for your participation.
I would like also to take a moment to thank all those who have provided the committee with useful and helpful background information, particularly the General Accounting Office and the Futures Industry Institute.
Our procedure today will be as it normally is. We will ask that the panelists summarize their testimony into 5 minutes or as close thereto as possible and to leave time for as much questioning as possible with those on the committee.
And I would now turn to my ranking member, Mr. Condit, for any comments he may have.
Mr. CONDIT. Mr. Chairman, I have no comments. I do have a statement to include in the record, if I may.
Mr. EWING. Thank you. Mr. Stenholm, the ranking member of the full committee.
Mr. STENHOLM. Thank you, Mr. Chairman. No statement. Delighted to be here.
Mr. EWING. If there are any statements for the record, they may be included at this time.
[The prepared statement of Mr. Barrett follows:]
PREPARED STATEMENT OF HON. BILL BARRETT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NEBRASKA
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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. It is important that we establish regulations that are fair and will allow our farmers to use the futures market as intended. I try to encourage the use of the futures market to allow producers with yet another valuable risk tool. I believe that this subcommittee will conduct a serious investigation of Over-the-Counter Derivatives, Agriculture Trade Options, Shad-Johnson Accord and all other elements included in this subject.
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.
Mr. EWING. We are ready for the first panel. Our good friend William Brodsky, chairman and CEO, Chicago Board of Options Exchange on behalf of the ad hoc coalition on intermarket coordination. Quite a title, Bill. Welcome. And Mr. James Cochrane, senior vice-president, strategy and planning and chief economist, New York Stock Exchange, and Mr. Richard Ketchum, president and National Association of Securities Dealers. We will start with you, Mr. Brodsky.
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STATEMENT OF WILLIAM J. BRODSKY, CHAIRMAN AND CEO, CHICAGO BOARD OPTIONS EXCHANGE, REPRESENTING THE U.S. SECURITIES MARKETS COALITION
Mr. BRODSKY. Thank you, Mr. Chairman. It is good to be back in your committee room.
Mr. Chairman, for those members of the committee who don't know me, I just want you to know that I have been in the investment business for 32 years, and I spent the last 25 years in senior executive positions at three exchanges. I spent 8 1/2 years at the American Stock Exchange in New York. I was president and CEO of the Chicago Mercantile Exchange for 12 1/2. And since 1997, I have been chairman and CEO of the Chicago Board Options Exchange, the first and the largest securities options exchange in the world.
CBOE's sole business is equity derivatives. We trade options on stocks and stock indexes. I also participated in many CFTC reauthorizations. I participated in the 1986, the 1990 which became the 1992 reauthorization, the 1997 reauthorization. I must admit when I moved over to the securities side, I didn't think I would be participating in any more CFTC reauthorizations, but I find myself back in this room.
I represent, today, the U.S. Securities Markets Coalition. That includes nine exchanges and marketplaces as well as the Options Clearing Corp. and the National Stock Clearing Corporation. With me today is Mike Vitek, director and special counsel of the Option Clearing Corporation who acts as the coordinator for the U.S. Securities Markets Coalition, Amy Zisook, vice-president of the CBOE's Government affairs division, and Howard Kramer who spent 17 years at the SEC and is now partner of Schiff, Hardin & Waite, our outside counsel.
We are here today to discuss three specific issues as it relates to this hearing. The first is futures on individual stocks, the second is options on narrow-based stock indexes and third is the status of equity swaps.
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As you, know the Shad-Johnson Accord is now 17 years old. It was and still is well-considered legislation. And its underpinnings are as valid today as they were in 1982.
The coalition strenuously opposes repeal or weakening of the accord and its prohibition on stock futures and industry narrow-based indexes or any attempt to limit the SEC's proposed review of such products.
I must say, Mr. Chairman, this is a debate not about whether futures on stocks or narrow-based indexes are a good concept or would make a viable investment product. That is not the issue at all. At issue is the impact of futures on stocks or futures on narrow-based indexes on the stock market.
And that is because of the regulatory disparities between the two markets and two different regulatory regimes that have existed in this country. And by the way, with all the talk about what goes on outside this country, I think it is very important for this committee to know that the United States is the only country that has different regulatory perspectives and regimes regarding equity derivatives. In every other country it is consolidated.
Now a word about the U.S. stock markets. The U.S. securities markets have been distinguished by the stability, the integrity, and the investor confidence that has become the hallmark of these investment markets. The securities markets have a very broad retail participation by over 70 million investors and that doesn't include those people that are invested in pension funds and other pooled instruments.
In many respects, that is not unlike the concerns that this committee has for the farmers who participate in the commodity futures markets and how they are a different constituency than those who use the futures markets for commercial or institutional purposes.
The proposals that are before you affect the fabric and integrity of the regulatory systems for stocks and related derivatives, and such changes must not be taken lightly. The Federal securities laws were designed for different purposes than the Federal commodities laws. Unlike securities, futures do not have any inside trading prohibitions. That may be fine when you are dealing with agriculture commodities and even Government securities or foreign currencies but insider trading in the securities markets is a very, very important thing.
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I want to bring to the committee's attention the lead story in the Wall Street Journal today which was just shown to me. On the very front page of the Wall Street Journal, it talks about the various issues on over night trading and it says, but stocks tend to be more volatile, more sensitive to specific information, easy to manipulate and more likely to be traded by individuals than market professionals. I think the Wall Street Journal not knowing that I was going to use this in the hearing today makes a very important point. The stock market is different from all other markets.
The other areas that are different is that we have suitability regulations in the securities business that apply to every recommendation made for a customer. The issue of margins or credit for the purchase of securities which distinguish the securities business dramatically from the futures business. Although they perform different purposes, the real bottomline is that leverage is a very important investment tool and can be used regardless whether you are using margin as a down payment or as a security deposit.
The SEC's view is that futures market leverage, the lack of key market protections such as insider trading could cause stock futures to be used in a way that might manipulate and otherwise abuse the stock market. The accord which was developed 17 years ago was designed to deal with these issues and the prohibition on stock futures and narrow-based indexes was specifically designed to keep this distinction separate from a regulatory point of view.
Significantly by the way, regarding narrow-based indexes, the SEC has approved approximately 70 applications for broad-based indexes submitted by the futures markets and only recently were two indexes turned down. But after 17 years, with the record of about 70 to 2, I think the committee should make note of the fact that the accord, overall, has worked very, very well.
Shad-Johnson, in our view, was carefully considered balanced legislation. These concerns should be completely addressed before any recommendations to change them are undertaken. We must avoid any action that will disrupt the securities markets and undermine investor confidence. It is essential that the SEC and its oversight committees play a major role in any such process.
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I'd like to point out to the committee the GAO report which just came out—and without rehashing it, I just want to read three of the public policy issues that the GAO report raised as it related to financial integrity, systemic risk, and market integrity as it relates to the stock index futures markets.
Number one, to what extent do futures on individual stocks and narrow-based indexes raise financial integrity and systemic risk or market-integrity issues that are different from those raised by options on such stocks and stock indexes?
Two, what implications, if any, are there to the efficiency, integrity of U.S. securities markets of separating the regulation of stock and stock index futures from the regulation of the underlying stocks?
And finally, what are the implications should foreign exchanges trade futures on individual stocks and narrowly based stock indexes?
Now just a final word on equity swaps that you mentioned. The issue that has received so much attention relates to the status of OTC derivatives. While the coalition has refrained generally from becoming engaged in the debate over OTC derivatives, we do have a particular interest in matters pertaining to legal certainty for equity swaps because the products' nexus to the equity markets.
The coalition believes that clarifying that equity swaps do not fall under the CEA would reduce unnecessary legal risk for U.S. financial markets. At the same time, granting the CFTC authority to exempt equity swaps from the CEA raises implications about the SEC's authority in regard to these products. The SEC, as regulator of the securities markets, has an important interest in investments involving the securities markets.
Hence, if Congress determines to provide greater legal certainty for equity swaps vis-a-vis the CEA, it should do so by excluding equity swaps from the CEA and making clear that the SEC has the authority to exercise appropriate regulatory oversight over these products. This approach was advocated by the SEC in its testimony before the committee in 1997 and again yesterday.
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Don't assume that equity swaps need to be addressed under Shad-Johnson. They could be dealt with without touching Shad-Johnson. Mr. Chairman, I know that there are many questions from the committee. I would like to wrap up by thanking the committee for the opportunity to speak with you. I look forward to answering questions and working with the committee in the coming months. Thank you very much.
Mr. EWING. Thank you, Mr. Brodsky.
[The prepared statement of Mr. Brodsky appears at the conclusion of the hearing.]
Mr. EWING. And now Mr. Ketchum.
STATEMENT OF RICHARD KETCHUM, PRESIDENT, NATIONAL ASSOCIATION OF SECURITIES DEALERS
Mr. KETCHUM. Mr. Chairman, thank you very much. I am Richard Ketchum. I am the president of the NASD. On behalf of the NASD, I want to thank the subcommittee very much for giving us the courtesy in allowing us to speak with you today.
By way of introduction, my background is somewhat different than Mr. Brodsky's. I, as well, have been involved in the financial markets for 25 years although a large part of that before I joined the NASD in 1991 was serving as a staff member at the Securities and Exchange Commission where, among other things, I was involved in the initial negotiation and application of the Shad-Johnson Accord.
In recognition of the committee's time and the often mind-numbing impact of opening statement after opening statement, let me just try to make three brief points.
First, the Shad-Johnson Accord recognizes that there are significant differences between the regulatory schemes that apply to securities and futures products. I want to make very clear to the committee and to you, Mr. Chairman, that I am not here today to talk about which of those regulatory schemes is preferable, whether one involves a greater degree of wisdom or anything of the like, simply to note that securities and futures generally carry very different risk characteristics, the investor base is also quite distinct and the regulatory schemes have evolved from that standpoint.
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Futures are traded overwhelmingly by institutions and by some relatively sophisticated, wealthy individuals. The strength of our securities markets owes much to the widespread participation of many millions of retail investors, many of relatively modest means. Futures products are purchased by commercial interests to hedge market risk and in some cases by speculators, but in any event not for long-term investment.
Because of the different characteristics of these products, many of the basic regulatory protections that apply to each are also very different, including account-opening procedures, customer suitability provisions, margin requirements, front-running restrictions, and market surveillance systems.
Because of the absence of a single integrated surveillance system, the trading of derivative products that are closely related to the underlying instruments, for example futures on individuals securities, could be used to skirt rules that apply to securities trading.
The second point I want to make, Mr. Chairman, is that recent developments in the securities markets have resulted in profound changes in the manner in which individual investors operate in those markets and, if anything, reconfirm the wisdom of the approach of the Shad-Johnson Accord some 15 years ago. In particular, I am speaking of the explosion of on-line trading and day trading in the securities markets, the empowerment that is provided individual investors to participate directly in those market places, both with respect to purchasing the stocks and the overlying options.
In that type of environment, the need for a single consistent regulatory structure and the need for a single consistent integrated surveillance system overseen by a single regulatory agency to ensure compliance with that system is greater than it ever has been before.
And finally, our desire today is to ensure the maintenance of the integrity of our capital markets, a desire I know that everyone on this committee equally shares. A contributing factor of people's participation in the equity markets is their confidence in the markets integrity and fairness. Anything that could potentially jeopardize that confidence could cause great concern to all of us. We should be extremely cautious when considering modifications that could affect these markets, particularly the stock market itself. Trading of futures on industry sector/narrow-based stock indices or futures on individual stocks could indeed affect the pricing of the stocks underlying those futures and increase stock market volatility.
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Mr. Chairman, the NASD is very much interested and enthusiastic about working with the committee on all of these issues, and again we want to thank you very much for the opportunity to testify.
Mr. EWING. Thank you, Mr. Ketchum.
[The prepared statement of Mr. Ketchum appears at the conclusion of the hearing.]
Mr. EWING. And now Mr. James Cochrane.
STATEMENT OF JAMES L. COCHRANE, SENIOR VICE-PRESIDENT, STRATEGY AND PLANNING AND CHIEF ECONOMIST, NEW YORK STOCK EXCHANGE, INC.
Mr. COCHRANE. Mr. Chairman, members of the committee, thank you very much for this opportunity. I, following the example of my colleagues, will try to be very brief. There are four points that I would like to touch on that are amplification of what is in the written testimony submitted.
I am here with my colleagues, Sheila Bair and Susan Milligan, behind me, from our Washington office, and we are focused, really in our written testimony on four items.
First, is the question of futures contracts on individual stocks or very narrowly cast or narrowly based stock indices. The New York Stock Exchange has been against the opening up of U.S. markets to these particular products, not necessarily for narrow commercial reasons but because we don't see any economic purpose being served by them.
We go back to basic principles. Why do we have futures markets in this country or around the world? We have futures contracts in agriculture because people are involved in cocoa, corn, sugar. Orange growers in Florida need to move risk from themselves to the market as a whole. Hersheys has a continuing ability to move the risk of lumpy needs for cocoa in their own plants.
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People involved in grain production at certain points in the crop cycle would like to avoid bearing the full risk of whether not covered by insurance. Futures contracts have historically performed a very important purpose in our economy, and they do in a financial arena as well.
We have many very large customers of the New York Stock Exchange, such as Vanguard in Philadelphia or BGI in San Francisco that are very, very large managers of pension funds where people have elected to tell their pension fund managers, please put my pension fund or 30 percent of it in a package of stocks that is essentially the Standard and Poors 500 stocks.
Vanguard and BGI and other firms get these flows from Exxon or from the NASD pension fund in lumps. They may get a $20 million lump. They don't want to put that immediately into the cash market. They want to work that new money into the marketplace, but they want to give the pension recipients some appreciation in the interim. So they will go into the futures market, take a position while they work the $20 million of new funds into the marketplace. These futures have a very useful role.
All the rules surrounding futures markets, whether they are for orange juice, frozen pork bellies, or Standard and Poors 500 contracts, the framework of rules and the law in this country are different than they are in the securities markets.
And there is a very basic reason for that. There are different margin requirements. Basically a margin in a futures contract is really a good faith deposit for performance. Going back to 1929, we had one digit margin requirements for stocks for securities in this country and what we discovered as we went into the aftermath of 1929 is that it is perhaps not a wise thing to have single digit margin requirements for people buying and selling securities. It is simply too dangerous. You don't want to give people ability to come up with one nickel in capital and lever that one nickel into a dollar's worth of purchasing power in a securities market. Securities markets for us are special.
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Going back to 1952, when the New York Stock Exchange first began trying to figure out how many shareholders there were in this country—it was our first attempt—the answer was 4 percent. Four percent of the American public in 1952 owned stock. That number today is 40 percent. We are now a Nation of shareholders. We now have over 70 million people in the United States participating in the equity markets. It is a special type of market.
We are not arguing to have a continued prohibition on futures because we think it would necessarily hurt our market. We are simply saying from a systemic point of view, the difference in the kinds of rules, the customer requirements, customer suitability, margin requirements, and all the other things that go with the securities markets as opposed to the more commodity-oriented futures markets argue for continued prohibition. We think they are different.
The final point is about three other areas that are in the various proposals that have crossed over our desks concerning the Shad-Johnson Accord, and these proposals I associate with the CME and CBOT.
First, they propose a elimination of the requirement that the CFTC approve futures contracts before trading. We think that would make it very difficult to make sure that these contracts are not conducive to manipulation. Also they are proposing excluding privately negotiated derivatives as Rick just mentioned, including those that are equity-based. We think we need to be very clear that if you do that, that these particular privately negotiated derivatives are subject to the securities laws.
And finally, the CME-CBOT proposals would eliminate prior approval requirements and transform the CFTC to a supervisory oversight agency. We are not sure what that means, but it seems a bit more passive than the kind of model which we think works pretty well where the NASD and the New York are monitored and overseen by the SEC, a process we think works reasonably well and it is definitely not passive.
Thank you very much, Mr. Chairman.
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Mr. EWING. Thank you.
[The prepared statement of Mr. Cochrane appears at the conclusion of the hearing.]
Mr. EWING. Mr. Cochrane, we will start with you, and maybe you could explain to us the difference between trading with equity swaps and derivatives and the difference in regulation that you understand or feel would be necessary or desirable?
Mr. COCHRANE. Yes, sir, Mr. Chairman.
Let's think about what does a futures contract for Exxon or Disney or IBM stock means. What customers are being served? If you go down to Irving, TX and tell Exxon: You are the producer of Exxon stock just as the person in Florida is producing oranges. Are you in need of some kind of exchange-traded futures contract that helps you?
They would say, No. 1, no, we don't need it. No. 2, frankly we don't really want one because we are afraid it is going to add to the volatility of our stock. If you go to the CEO's of the Fortune 1,000 companies, I would be willing to bet that they are very unhappy about the notion of having futures traded on stock of their companies. So in terms of the producer of the item, they not only are indifferent, they are negative.
If you go to the investment community, the ultimate holders of the stock or my brother as a private investor basically running a construction business in Pennsylvania who spends 5 minutes a month worrying about his portfolio and ask him is there some economic purpose to you, some value of having a futures contract on IBM, Disney and Exxon, he would say no, I don't need that. If I am falling out of love with those stocks I will sell them or I will sell a portion of them.
So, I understand what frozen pork belly contracts do. They serve an economic purpose. I don't get it with reference to individual stocks. So we begin with a puzzle. You are trying to take a contract in a security which we have terrific markets in.
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We have worked 70 years in this country not to have 1929 replicated. We have a 70-year history of securities laws to make sure that when we finish up tonight at New York, we will tell you—don't hold me to this, but let's say the last trade in Exxon was at $78 per share. I think most people in this room will be pretty comfortable and confident that that price was fairly arrived at. There was not a lot of shenanigans there. Was not a lot of professional insider dealing. It wasn't a bunch of insiders in the company moving the price around because they had special information.
We don't have those kinds of standards in the futures market because we don't worry about Coca-Cola being the world's biggest user of sugar. We don't say because you are the world's biggest user of sugar, you can't play in the commodities markets. We say you have got a legitimate reason to be there or we have got to come up with some rules to make sure the system works pretty well. We have got a framework of rules in the futures market that are applicable to those kinds of products which belong there.
We argue that contracts on individual stocks and very narrowly cast indices, do not belong there, and certainly if you put them there, the business that gets done will be done because of regulatory arbitrage because people say I don't want to put up 50 percent margin requirements to buy in a cash market. I want to go with that 5 percent margin requirement in the futures market.
Mr. EWING. Are you indicating that the futures market is subject to manipulation? I kind of had that feeling that your market is very safe and sound and the futures market is the one where all the manipulation is in.
Mr. COCHRANE. Mr. Chairman, I would say that the futures markets are markets for professional——
Mr. EWING. Answer my question.
Mr. COCHRANE. The answer to your question is no.
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Mr. EWING. You keep using that as an excuse for this but if it isn't the problem, then it isn't the excuse. My question is are there other people out there—the markets are not just for the CEO of Exxon or your brother. I mean, there are thousands of people who want to use these markets. Are there needs for these markets?
Mr. COCHRANE. There are definitely——
Mr. EWING. Are you saying no need for anyone to have that option of using a futures contract on an individual stock or a narrow-based indices?
Mr. COCHRANE. Yes, sir. I think what I have been trying to argue is there is no economic purpose—one hates to take other countries' experiences as examples for what we should do. But if you look around the world in the national jurisdictions that have experimented with futures contracts and individuals stocks—and the ones that come to mind are Australia, Singapore, Hong Kong, Sweden, perhaps South Africa. There is some anecdotal evidence that these exist in some other countries, but I can't find any evidence of them. When I looked at the testimony yesterday about millions of shares of contracts being traded in these markets, that tells me, gosh, maybe there is something that is useful.
My first question is is it being done because of regulatory arbitrage. I look at these Sydney Futures Exchange promotional literature and it says, Mr. Chairman, ''Due to the leverage available by using our share futures contracts, investors can potentially generate sizable profits on relatively minor market moves. We have initial margins less than 5 percent. Traders are able to gain leverage exposure to these great Australian blue chip stocks.''
I also notice that contrary to the numbers that were used yesterday, the average daily volume of these contracts in Australia is rounding error. It is 25 contracts traded per day. To put that in context, 37,000 S&P 500 contracts traded at the Chicago Mercantile Exchange yesterday.
In Stockholm, the man who runs OM Group which runs the Stockholm futures business, said the futures on individual stocks trade by appointment only. There is a very low level of business.
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These markets may operate in other jurisdictions such as Hungary and Finland. I have heard that anecdotally, but I am not able to track down any evidence. My point is when they have been offered, they essentially have not drawn any interest.
Mr. EWING. My time is up, but we are going to have, hopefully, more than one round of questioning here. And I say to the panel, you are the experts. We are trying to feel our way through this, and we are also trying to sort our way through competing business interests that are represented on that side of the table, and we ask for, certainly, your help and your candor in trying to get that information out there and really whose ox is gored and is it just the old profit motive or really what—we want a system that is safe for America, but a system that works and we get, oftentimes here in Washington, people from the business community come here for their own personal advantage that they can get by passing certain legislation or not passing it and it makes our job tough, particularly when we don't understand all that.
So I am now going to Mr. Condit.
Mr. CONDIT. Thank you, Mr. Chairman.
I would like to ask, and I guess Mr. Cochrane might be the appropriate person about the equity swaps. Regarding the legal certainty, what is the difference between the administrative exemptions that already exist and the exclusion you seek from the changes in the CEA?
Mr. COCHRANE. Mr. Condit, I think the area of equity swaps, we are focused on swaps that have equity content built into them. We are focused on making sure that the Securities and Exchange Commission has as much of a chance as possible to make sure that we understand and we regulate and we follow in this country this activity as closely as we can and to make sure it is as transparent to the system as possible. And all of our concerns has been in the contractual or customized swap area is the possibility for systemic risk where you simply don't know what is out there. So we operate on the premise that let transparency prevail as much as it can prevail and let the Securities and Exchange Commission in the equities arena have as much authority as it needs to do that job.
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Mr. CONDIT. Just to be fair, either one of you gentlemen want to take a few moments to respond to anything, you are welcome to do so.
Mr. Cochrane, if the swaps are excluded and no longer regulated by the CFTC, what Federal agency, if any, should regulate these products?
Mr. COCHRANE. Mr. Condit, we think in the equities areas or as these products have significant equity content that the logical locus of jurisdiction would be the Securities and Exchange Commission.
Mr. CONDIT. So I can get the other two players into this, as quickly as the three of you can, can you give me your best shot, what would be the most important reform Congress could make for the purposes of the futures and securities trading commodities?
Why don't we start with Mr. Brodsky?
Mr. BRODSKY. Well, I would refer to the chairman's opening remarks where he said that the three priorities that he had were regulatory relief, legal certainty on equity swaps, and the Treasury amendment. In that context, if the committee were to follow that and not interfere with what I would call the sanctity and the good functioning of the Shad-Johnson Accord, then from my perspective, I would be very much in support of legal certainty for equity swaps consistent with Mr. Cochrane's points. I believe an exclusion from the CEA is the proper way to go because in equity swaps, and anything in the equity area such as equity swaps ought to be reserved to the SEC.
In terms of regulatory relief, that is a very broad issue; and I am very sympathetic to the concerns of the futures exchanges trying to balance the not too burdensome regulation by the CFTC in keeping the futures markets competitive with the rest of the world.
The only issue that we have, as I said to you, is the issue of Shad-Johnson, and with regard to the Treasury amendment, that is not an issue that we have with the committee.
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The Treasury amendment is another one of those things like Shad-Johnson which was crafted many years ago to deal with issues of Government securities and the foreign exchange markets and, of course, what has happened is the markets have grown beyond anybody's expectations. It is very hard to just sit here and make decisions without hearing from lots of people.
But I would agree with Chairman Ewing that these are three very important areas of concern, and I think it is very important for this committee to understand. And I hope I made these points in my opening comments; I will reiterate it now, particularly in terms of Chairman Ewing's question to Mr. Cochrane in the first round and that is, I don't think this is really an issue of whether futures on stocks is a good idea or a bad idea.
What we are dealing with is an accord that was sorted out 17 years ago to try to recognize that there may be an area where the CFTC could have regulatory jurisdiction over something that related to the equity markets. But that when you get beyond broad-based indexes, then the SEC has a vital interest because you are dealing with millions of public investors. In fact, many, many more times the amount of investors in the stock markets than existed in 1982 exist today. And I think, therefore, the U.S. Government's regulatory scheme on equity markets play a very important role in how you handle Shad-Johnson in the current environment.
So I agree again with Chairman Ewing in terms of what his priorities are. And when we get to only one part of the regulatory relief that the futures exchanges have sought, do we have what I would call a substantive disagreement. The rest—we can talk about specifics if you would like. I certainly would be happy to try to answer those, but I think, in general, I am sympathetic with the desire to have some regulatory relief.
I am concerned, however, in the area where they would change the CFTC to an oversight agency. No. 1, I don't know what that means and No. 2, if it were to relate to the equity derivative products that currently trade our future exchanges, I also would have a serious concern because of the desire to try to keep these markets working together and have some regulatory coordination—which is what Shad-Johnson was all about.
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Mr. CONDIT. Thank you. Mr. Ketchum.
Mr. KETCHUM. I agree very much with the points Mr. Brodsky made. I would just briefly state them. First, with respect to legal clarity, I believe that is an important thing for this committee—with regard to the question of legal clarity for swaps, particularly with regard to privately negotiated swaps among sophisticated individuals, I think that is an area in which additional clarity would be highly valuable.
With respect to regulatory relief, I would not presume to suggest what the correct answer is with regard to the relationship of the CFTC and the futures exchanges but certainly can imagine there are changes that would be beneficial.
I would note that on the securities side, the SEC had a far more removed environment with respect to self-regulatory organizations up through the 1960's with respect to their not being involved, generally speaking, in approving rule filings. I think Congress reached a conclusion that that had not worked as effectively as it could. I think it might be worth looking at that history before concluding that simply an oversight agency is a good idea.
And again, to underline, I agree with Bill, this is not about whether futures on individual stocks is a good or bad idea from my standpoint. I think that is something I tend to not claim to be smart enough to know. That is a matter for the market. It is a question that markets that directly impact each other, that can be used as part of manipulative schemes or part of insider schemes not because of a problem in one market versus another but just simply because of the economic and trading relationships between those products, should be subject to a single regulatory scheme and be overseen by a single regulator with the same types of audit trails, same types of rules, and the like, particularly when they relate to a marketplace that is so important to the national interests of the stock market.
Mr. CONDIT. Mr. Cochrane.
Mr. COCHRANE. Nothing to add, Mr. Chairman.
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Mr. CONDIT. Thank you.
Mr. EWING. Mr. Thune.
Mr. THUNE. Thank you, Mr. Chairman, members of the panel. This is very helpful as we try and sort through what I think are the complexities of this subject and many of us have and myself included—I can't speak for the other members of this panel—I have a lot to learn on the issue so I appreciate the testimony.
Most of you have voiced opposition toward repealing Shad-Johnson, and one of the concerns that has been raised is that margins for futures are different for margins for securities options. I guess what I am wondering is do you believe that it is possible to harmonize future margins with securities margins and would that address your concerns about repealing Shad-Johnson?
Mr. BRODSKY. I would be happy to try to answer that. I think that you have to first start off with the premise that futures margins and securities options perform different functions.
One is a down payment in the case of securities margins, and in futures it is a security deposit. So I don't think you can harmonize them in the way that would make them economically the same. But the problem is that investors can use these products based on how much money is put down irrespective of what function the deposit makes. And, therefore, we view the fact that the structure is different is irrelevant to the fact that you are dealing with an instrument that transcends the regulatory schemes.
A futures contract, to use Mr. Cochrane's example on Exxon, really will have a very similar economic and trading purpose as a stock of IBM or an option on IBM. And it is, therefore, our belief that you have to have them under a common regulatory jurisdiction. If you had a futures product on stocks regulated by the SEC, our concerns would not be the same as if they were regulated as a futures product under the CFTC regulatory structure and environment.
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Mr. KETCHUM. I would agree with what Mr. Brodsky said. Regulation of margins as well as customer investor protection regulations and assurances of the right type of market surveillance systems and the rest is not a one-time harmonization act.
It is an ongoing review in which you need an expert agency to be focused on and have consistent authority over all of the products. And what our experience was with respect to margins on stock-index futures, staying away from the question of the rights or wrongs of that area, was that single efforts to change those margins over time evolved because of changes in prices and other actions in the marketplace.
So I don't think a one-time harmonization, Congressman, would have the impact that one would be looking for.
Mr. THUNE. Let me, Mr. Ketchum, followup on that. I am interested in your remarks and your testimony on surveillance talking about harmonization. Has the inner market surveillance group ever considered moving to a, sort of a single, integrated surveillance system between CFTC and SEC, and do you believe it is possible to harmonize the surveillance system?
Mr. KETCHUM. I think anything is possible. The difficulties with respect to harmonizing the surveillance system is in ensuring an ongoing regular exchange of information and an oversight with respect to a single decisionmaker as to what types of information should be collected, how the audit trail should look, what types of concerns there should be, and how they should be focused on and the resources applied to them.
It is not to say that one entity is more wise or less wise than another entity, only that when products are integrally related, I think the only way to effectively do it, while the NASD is a beginning step, is to have the oversight of a single entity so that there is a single approach applied across the board.
Mr. THUNE. Mr. Brodsky, you mentioned in your testimony suitability provisions.
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Could you explain to the committee how those provisions work, how they apply and how would you make a determination that, for example, a customer is unsuitable to trade?
Mr. BRODSKY. Yes, I would be happy to try.
First of all, I think the basic difference between suitability in the futures markets versus the securities markets is that in the futures markets, there is an initial suitability determination of whether an individual has the ability to trade and deal in futures markets in a general sense.
In the securities markets, suitability is based on recommendations to customers on a trade-by-trade basis, and so there is a very stark distinction between the two. Recommended transactions in the securities world have to pass a suitability test each and every time there is a transaction, and I think that itself is a very, very important distinction.
Mr. THUNE. What would happen if you applied suitability provisions to futures?
Mr. BRODSKY. Well, as I said, it is a very generic kind of test in the first place and, quite frankly, I think that if you apply it, what may be suitable for the individual at the time that they open the account may not apply later, No. 1, and No. 2, it may not apply to each and every transactions that is made for the customer.
I think that, to be very blunt about it, what has happened over the years is the amount of retail participation in the futures business has declined dramatically because many customers have found that they cannot make money trading futures as retail customers, and they tend to go toward managed funds where in the securities business, we have seen a tremendous explosion of investor interest in the securities business.
And the amount of people who trade as retail customers of securities business is staggering in terms of its number, and I really think it is an apples, oranges comparison. It is very hard to make that comparison.
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Mr. THUNE. I see my time has expired, Mr. Chairman. I yield back.
Thank you for your answers.
Mr. EWING. Mr. Dooley.
Mr. DOOLEY. Thank you, Mr. Chairman.
Mr. Cochrane, I am a little interested in terms of the issue in terms of trying to understand better why we shouldn't allow futures on individual's stocks. And using—your example, was your brother-in-law that looks at his portfolio only 5 minutes every month.
What happened if your brother-in-law had the $20 million stake in Exxon and was interested in selling that stock but wanted to do it over a period of time? Why shouldn't we allow him to have a market tool that might be a futures in that stock that would allow him to perhaps manage the sale of that stock?
Mr. COCHRANE. Congressman Dooley, No. 1, we would hope that the individual could bleed down or reduce an inventory of any given stock without too much market impact at a pretty good pace. And second, options on the stock are available so that if for some reason they wanted to hold a cash position but take the kind of jump that I associated with Vanguard when they got the $20 million new cash flow, then disburse that into the marketplace.
Mr. DOOLEY. I am having trouble understanding why we are not concerned about Vanguard or some big institutional investor that we think it is appropriate for them to take a position on a futures on an index because they want to manage some of the risks or the volatility and, yet by the same token, we are trying to make the argument that if we have an institution or an entity that is trying to maybe have a position in a single stock that might want to be exiting it or even entering it, that they shouldn't have that same tool available.
If it is good for one set, why isn't it good for an individual? I am having trouble understanding that.
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Mr. COCHRANE. In the one case, someone is putting up the equivalent of a good faith performance bond that they will, in fact, perform. It will be marked to market each day, and if they need more cash, they will come up with it.
The person with the position of the individual stock, No. 1, can sell his portion of the stock, No. 2 can use options to accomplish the risk movement that you have described. A bigger concern is an environment in which we continue the trend that we have been in so far in 1999, which is that 1999 is turning out to be one of the most volatile years in cash equity markets, us and Rick's market, for the last 23 years, and we have increasing amount of volatility.
We have increasing amount of very large percentage movements in stocks, not just the most recent Internet IPO but lots of stocks. And you get concerned about the ability of someone to come in on a very low capital base and have a great deal of buying power in that market where your public policy is asking the New York Stock Exchange and the NASD to provide a regulatory regime that protects the integrity of what is going on in the cash market.
And we require 50 percent margins. We have learned that lesson over the years. We do need high margin requirements on stock. And at the same time, you are going to have a parallel market perhaps becoming the tail wagging the dog in terms of pricing the stock in which you have got a different set of rules of the game. You do not have customer suitability requirements. You have got lower margin requirements and you have got different rules on insider trading.
It just seems like we have got two markets that work pretty well for two separate categories of users; and by breaking down the barriers between those two, you open up the possibility of some difficulties.
Mr. BRODSKY. Congressman Dooley, let me give my own perspective on that, if I might. I think from our perspective, we are not questioning whether the concept you are talking about is viable or whether it is economically appropriate. I think it is merely a question of the regulatory disparities, and we can conceive of a situation where all equity derivative products are regulated under the SEC and at least the objections that many of us have would evaporate. I think that is really the issue more than anything else.
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I will make a quick pitch, though, that is for that friend of yours that has all that Exxon stock. We trade options on Exxon. And I could probably show you that they would be better off using our options than a futures contract; but that is a business argument, not a legislative argument.
Mr. DOOLEY. I wouldn't necessarily disagree with whether the options or the futures would be a better alternative, but I am not sure that it is the Government's role to make that determination, and that ought to be a decision that should be decided by the marketplace.
And I think of what I hear you say is that the issue is not whether or not this is an appropriate financial tool that should be available but whether or not we have the adequate transparency and the regulations that are consistent to ensure that they, in fact, are not adversely allowing for manipulation of the market itself.
Mr. BRODSKY. That, in fact, is my point that there should be harmonious and consistent and uniform regulation on equity products. An option on IBM and a stock of IBM or the futures on IBM ought to be regulated under the same rules by the same regulator.
Mr. DOOLEY. Thank you.
Mr. EWING. Mr. Hayes.
Mr. HAYES. Thank you, Mr. Chairman.
Just an observation and you all across the board and across several days of hearing referred to regulatory schemes. Is that a slip of the tongue or do we have regulatory plans or do we have regulatory schemes here?
Mr. BRODSKY. The term regulatory scheme is not pejorative, but rather that there are regimes. The securities regulatory scheme is based more on disclosure and investor protection and the futures regulatory scheme is much more based on speculation in the markets and commercial hedging. It just has a different kind of fundamental philosophical background.
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Mr. HAYES. It isn't really a scheme. It is a plan.
Mr. BRODSKY. Right.
Mr. HAYES. What is the essence of the discussion here? I mean, I have heard good questions about blending the options and the futures and the stock exchange and the board of trade. There is a product. And I don't presume to be conversant in all the intricacies of financial markets; but if you wanted to use something called a collar, how does that fit into this discussion? If you had $20 million worth of Exxon, some financial institutions would offer you a collar on this stock. How does that fit into this picture?
Mr. BRODSKY. I would be happy to answer that because I represent the stock and options exchanges in the United States. The options exchanges provide a variety of ways of using options to protect stock positions and a collar is one way to do that.
A collar an investor who has a large stock position the ability to protect that position for either low-cost or no-cost insurance, and the way a collar works is an investor sells calls above the price of the stock. If the stock is $100, you might sell calls at $105 and you might buy puts at $95. And the sale of the call produces a premium which pays for the cost of the put. I hope that is not too complicated.
Essentially what is being done is you are protecting the value of the stock within a certain trading range and not paying for the insurance. I am happy to tell you that since the CBOE was established 26 years ago, the investment community, through major brokerage firms around the country, have used options the way they were intended to be used and that is to provide insurance for customers who have big stock positions and provide them with ways of holding on to their stock and yet not having the downside risk of owning the stock. And a collar is a very, very important tool in that investor's arsenal.
Mr. HAYES. So we have got options. We have got futures. We have got collars. Are we missing anything else?
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Mr. BRODSKY. A collar is just a combination of options. A collar is a way of taking two options and being able to put them together to create what is known as a collar. So there are options, futures, and stocks. When you are talking about the equity markets are the three fundamental things. Then there are equity swaps which do not trade on exchanges.
Mr. HAYES. What do you want us to come away from this understanding in terms of where we need to go? Do we need more regulatory plans, less regulatory plans? Who should be the referee in this?
Mr. KETCHUM. Congressman, I think if we leave you with one message, it is that the carefully negotiated process that occurred in the 1980's that led to the Shad-Johnson Accord resulted in a definition and division that was focused on the differences between two markets, that made sense then and makes even more sense now. The importance of allowing those markets both to evolve but the assurance that when you move down to something that emulates an individual stock unlike a stock index, that the risk of—in an effectively integrated market—market manipulation, insider trading, or potential impacts on investors or adverse impacts on investors were simply too great to operate with respect to two regulatory agencies overseeing that marketplace.
Unless that changed, it is preferable to maintain a Shad-Johnson Accord and not to have futures on individual's stocks or on narrow-based indices. I think the message we would leave with you is that the Shad-Johnson Accord was a carefully thought through effort in a lengthy process involving the exchanges, the regulators and both Houses of Congress in a series of oversight hearings and, if anything, it remains more valid today than it did in the past.
Mr. HAYES. I appreciate your patience with me. The last question I would ask—my colleagues are much more learned in this for the most part than I am.
As I evaluate, this what can you tell me that would lead me away from the thought that a lot of what you are talking about here is to sort of avoid additional competition? It seems like again there is the internal competition between the different marketplaces and you are trying to—and that is nothing unnatural, but you are tying to maintain parity as opposed to opening up more competition.
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Mr. KETCHUM. Congressman, we don't have a dearth of competition in the securities markets today. In fact, the SEC has taken a variety of steps in the last 2 years to effectively reduce any barriers to new markets becoming exchanges.
We have electronic trading systems of a variety of type and description that occur with extremely low entry costs. And I think that there is not a problem or an issue with respect to the ability to develop new products in the U.S. securities markets today. Our only desire is for that competition to occur in a single consistent regulatory environment and not outside of that, that is our only concern.
Mr. HAYES. Thank you. Thank you, Mr. Chairman.
Mr. EWING. Mr. Baldacci.
Mr. BALDACCI. Thank you, Mr. Ewing. I want to thank Mr. Ewing for holding these hearings and for having this very informative process this week and the free flow of questioning back and forth as I look forward to working with him on this endeavor.
Maybe it has already been talked about. I may just be redundant, but it seems to me that the world is becoming smaller and smaller and the European Union is consolidated to a union and being a recognized economic powerhouse.
And it appears that the United States is somewhat reluctant to adapt market forces to a market to be able to remain in the leadership role that it is in. And I was just reading about how the stock market would be transformed by a 10:00 p.m. closing, and it kind of reminded me of the grocery store that just started to recognize that maybe people don't work just 9:00 to 5:00 anymore, and they had to be opened from 5:00 to 9:00 and I would like to hear your comments as to how you see it evolving on a world scale. Mr. Cochrane.
Mr. COCHRANE. Thank you very much.
It is a very thoughtful and complex question. Very brief answer. Every institution represented at this table is in the process of stepping up to a reality where there is no God-given reason that we are going to exist 5 years from now. We are facing a great deal of competition in the world that we are in in which more and more of our customers are interacting with each other over the Internet and other low-cost electronic media.
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The concept of a national border as the locus for public policy and securities regulation in our business increasingly is a difficult circle to square. The challenges that we face are fairly enormous. And we look very carefully at where we and our regulator, the SEC, need to be more creative or more flexible in redesigning our businesses so that, in fact, we are around 5 years from now and we can compete with our major competitors in other parts of the world and, frankly, within this country the competitors who are not represented on this panel.
The concern that we have on some of the issues that are on the table today is that we think there are some areas where you may end up taking a step backward defended by the need to be more internationally agile or to be more creative in reacting to cross-border challenges. I do not think that all of the challenges faced by the financial services in this industry, financial services industry, would be helped by permitting the inclusion in our arsenal products—a product which I think would change the landscape in the way we may not like.
And we may turn around 3 to 5 years from now and be very uncomfortable with the results of what we have created. Nevertheless, we face an extraordinary competitive environment where we continue to look at our next set of competitors coming from the Cayman Islands or the Jersey Islands or Hong Kong, offshore Hong Kong. We have people trying to do our business in a variety of ways that circumvent the framework of rules that we built in the United States.
And it is a challenge. So far I think we are doing pretty well because people do like to come to the United States both to list their stock, to issue stock, raise capital, and make investments and trade on our exchanges because they like the way the system is run.
Mr. DOOLEY. I won't want to engage in a debate in regard to that, but I would just say that a lot of the history of the country—that the growth in the industries has been when sometimes things can go on a little bit more unfettered with the ups and downs.
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But certainly the development of the Internet and all of that that has taken place and the evolving of that certainly by itself is a good example of what can happen in maintaining our country's leadership role in information technology as a byproduct of that. Not to say that there aren't problems with it; but at the same time, I think it is important to remember that we want to maintain that position.
The only other question I have is that in some of the correspondence—maybe Mr. Brodsky can answer this. It seems that there is an appearance that there is an opportunity for market manipulation in individual stocks and maintaining that ban against being able to do that, and I would just ask you, what was the experience to get to that particular position that it could possibly happen?
Mr. BRODSKY. I think there is always—in any marketplace, concerns about manipulation. The concern that we have is that it is more likely that you will have an attempt at manipulation in an individual stock than in a broad-based index of stocks, and that is why the accord was drafted to make a very clear line that a broad-based index future would be allowed to trade under a CFTC regulatory scheme.
But it was very clear then, as Mr. Ketchum said and it applies even more so today than it did then, that if you are going to have futures on individual's stocks trading or narrow-based indexes that because of the concern about the potential for manipulation, that the regulator that is most expert in securities markets and equity markets is the SEC and that they should have unfettered control over the supervision and surveillance of those markets.
Mr. DOOLEY. Thank you.
Mr. Chairman, I see my time is up. I would just ask maybe as an opportunity to gain information to see what the experience is of the exchanges to be able to monitor their exchanges and to determine whether in fact the facts bear that out. Thank you.
Mr. EWING. Mr. Gutknecht.
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Mr. GUTKNECHT. Thank you, Mr. Chairman. I must tell you the last several days of hearings particularly these witnesses I want to thank for coming.
I would apologize. Just so you understand, there are many of us who have other meetings going on at the same time. It is not that we are not interested in the subject. I have another meeting that starts in 10 minutes. There are Members who really do want to know more about this.
I have been trying to sort out in my own mind. First an observation, and then I will get to a question. The whole issue of why do we regulate? Why do we have rules? Why do we have regulations? Ultimately, it is to protect consumers presumably.
There is a difference. And I come to this from a variety of different perspectives, but one of them is that I served in the State legislature in the State of Minnesota. For 10 of the 12 years I was in the legislature, I served on the gambling subcommittee. And at every turn, I tried to keep Minnesota from going deeper into gambling. I voted against horse racing. I voted against the State lottery. I led the fight against opening up the State to other forms of gambling, and I lost every one of those fights.
But nonetheless, we still have in the State of Minnesota something that is very important. In the State of Minnesota you cannot sue to collect gambling debts in a court in the State of Minnesota. So gambling is legal, but you cannot collect gambling debts in a court in the State of Minnesota.
That is true in most States. Because we have said that, in effect, we permit this activity, but it is laissez-faire. You are on your own. If you gamble amongst friends and you lose or you win and you don't get paid, that is your problem.
Every stock and every future contract, whatever kind of—however exotic you want to get, every one of them is bought by someone who believes the rest of the market is going to go up, and every one of them is sold by somebody who believes relative to something else it is going to go down. That is the way the market works.
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I believe in markets, but I do think we ultimately—as a committee we have to sort out the difference between investors who go to the table and buy a 100 shares of IBM or a 100 shares of Exxon or a 100 shares of Lucent Technologies or whatever the company is or they sell those shares and somebody who brings to the table only a 5 percent margin call, I think there is a difference. And I think there is a difference in whether that is investing or is it speculating and it seems to me as we go down this path towards what we are going to do with this, we have to bear that in mind. That is my first observation, and it is for the benefit of the members of this subcommittee.
My question really is—and if you want to make a comment to that, I would be more than happy to listen to it, but my question is sort of pursuant to what Mr. Baldacci talked about, and that is as you look at this thing, I really do believe markets are more powerful than armies.
That happens to apply to milk as well, to my colleagues who come from different parts of the district. Ultimately milk ought to be allowed to set its own price. We have this very convoluted system in the United States which we will argue again about in this committee ad nauseum. But markets need to exist and they will exist and they will find their most efficient way of moving goods and services about. So if you could look into your crystal balls, where will these markets be in 15 or even 5 years from now?
Mr. BRODSKY. When you say where will the markets be, what are you referring to?
Mr. GUTKNECHT. How will these transactions happen? I believe e-commerce cannot be stopped, and e-commerce is a wonderful thing if you are a web-based operation. It is a terrible thing if you happen to have a bookstore and you have a huge investment in Winona, MN.
There was a bookstore in Winona that just closed in my district, and one of the reasons they cited is they can't compete with Amazon.com. They have a huge investment in inventory. Pay property taxes and all the rest.
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And I think whether you believe it or not or like it or not, that is also happening in your market. I am just wondering where you think the market will be. How will these markets function 10 years from now?
Mr. KETCHUM. Congressman, I think your question and your points are quite intriguing and very thoughtful. I think, from my perspective, a variety of things you can expect.
One, the markets will continue to be more electronic. They will demand immediate access. They will only work, and we will only retain our position of superiority in financial markets, if the U.S. markets continue to distinguish themselves through the commitment of capital and liquidity whether it be by market-maker specialists or whatever system and an environment that encourages risk-taking as opposed to simply placing orders in a black box without any accountability or risk-taking.
In that context, I expect that the markets for derivatives and underlying securities will converge, often will be quoted together. You will be able to gain combination executions in an effective means, but I think the manner in which that will work will be if there is an environment in which liquidity providers can still profit. They will occur not simply in convenient hours in the United States but trading will occur throughout the day and night.
Mr. BRODSKY. Let me add one little bit of statistics to the comments by Mr. Ketchum that I agree with completely. I will give you two statistics. One is 85 percent of our business now comes in electronically, and that will only go up. It is clearly a generational change.
It is happening either directly by customers through their PCs or through brokers who talk to a customer on the phone and enter the order electronically.
The second thing, it is incumbent upon all of us both at the Governmental level and the regulatory level where we are at the marketplace level to educate consumers. I think it is very important for people to understand what it is to invest and how to properly manage their investment futures.
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One of the most interesting things that has happened with us, we created a website about 2 1/2 years ago. In January 1997, we had 50,000 hits on our website. Two years later, it was 50 million which I think goes exactly to your point of the rapid increase in the use of the Internet and how people are using it.
We have an opportunity here. We are at the leading edge of it. And as Mr. Ketchum said, if we can continue to maintain the leadership, the whole economic value of this country in the way people manage their assets will be enhanced because of the Internet and education that we all engage in.
I will make one last comment, Congressman and that is that your comment about people who sell stock, they sell it because they think it is going down. I would not entirely agree with that.
The difference between stocks and derivative products is that stocks are assets and a store of value. Derivative products are risk management tools; can be used for speculation or managing risk. People might sell stock so they can buy the house of their dreams. They are not necearilly selling the stock because they think it is going down but because they held it for a period of time and now the reason that they have put that money away for is coming to fruition. And they are selling it not because they think the stock is going down but because the reason they owned it in the first place is now coming to some goal that they can apply it to.
Mr. GUTKNECHT. You would agree though there is a difference between a family that is investing for their dream house or investing for college or investing for their retirement and they are buying real assets to use your term and some of the Internet cowboys that are developing day traders and all of a sudden they begin to realize it is not about owning IBM.
It is about owning an opportunity to watch IBM go up 3 points today and only having at risk a 5 percent margin call. I mean, you would acknowledge there is a difference and it seems to me——
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Mr. BRODSKY. There is a dramatic difference between speculating and investing, and I am distinguishing between the two.
Mr. GUTKNECHT. There is a difference at what level of regulation we should have. If it is laissez-faire, and somehow then you are out there on your own. There is sort of a different environment. I am just trying to figure out, from our perspective, what level of regulation should we have for different types of investments or speculations, whatever you want to call them?
Mr. BRODSKY. I think the hallmark of the U.S. securities markets has been that there has been a substantial level of regulation that has served the markets well. It has provided investor integrity and confidence in those markets without trying to tell people how they should invest their money. I think what is important is that the markets have a high degree of integrity and transparency.
Mr. GUTKNECHT. Thank you.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Thank you, Mr. Chairman.
Thank you again for this hearing. Very intriguing line of questions from my friend, Mr. Gutknecht. I think I will just follow it up.
The stock market trading is not gambling. And, therefore, while the laissez-faire treatment of gambling debts may be appropriate in that sector, stock market trading is quite different and does require, I think, integrity but broadly understood public integrity and transparency just as you mentioned, Mr. Brodsky.
I think that would be extraordinarily important. One of the things we are wrestling with is trying to look at the CFTC and its operations and evaluate whether there might be a greater self-regulatory role within the governance of futures similar to the dynamic captured in securities tradings with the NASD and the SEC.
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Mr. Ketchum, is it a fair characterization to say that the self-regulatory activities presently performed in the securities world deals with some of the micromanagement or the nitty-gritty details of the business while the SEC oversight tends to be more of a broad plane and one that is not as perhaps interventionist in the overall day-to-day activities in the business as presently happens in the futures world?
Mr. KETCHUM. I wouldn't want to compare it to the futures world, Congressman.
I think your characterization is fair. The NASD and the New York Stock Exchange and the Chicago Board Options Exchange with their focus on the options regulations side are in many ways the arms and legs of the SEC.
It would provide a substantial leverage of resources for the Federal Government and for the Commission in a user-based way that, I think, is highly desirable. It does result in, I think, very knowledgeable regulation and the SEC does hold us to very high standards of the breadth and care in which self-regulation occurs.
I think that the Commission is certainly by no means inactive with respect to that oversight, and they do retain the expertise necessary for effective oversight. But they do delegate a great deal of regulation to us, and I think the result has been a successful system over the years.
Mr. POMEROY. I imagine you have a constant ongoing dialog literally daily as you discharge your respective regulatory functions?
Mr. KETCHUM. Yes, sir. Sometimes it seems that it is hourly but, yes, we do. The SEC both oversights us directly with oversight examinations of the NASD as it does with the other self-regulatory organizations. It also does a series of oversight broker-dealer exams to look and make sure we are doing the right things.
And they look at our market surveillance programs in the same way. They conduct active and vigorous oversight. There is wide-ranging, I think, respect and conversation that occurs amongst us.
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Mr. POMEROY. An earlier witness said self-regulatory organizations is an adjunct to regulation, not a substitute for regulation. Across the panel, would you comment on that, starting with Mr. Cochrane?
Mr. COCHRANE. I am not sure that adjunct is the word that I would choose.
I would argue that our organizations as represented on this table are the first line of regulation as far as the—our member firm performance following the rules are concerned. We are the first line of investigation.
And second, that we are the first line of surveillance to make sure that our markets are being run properly in accordance with the rules.
Mr. POMEROY. That is a fair point. I think the thought that was trying to be conveyed was consistent with that, but adjunct is probably not the right word. Mr. Ketchum.
Mr. KETCHUM. I would agree very much with what you said, Congressman and Mr. Cochrane. I think self-regulation is a critical part of the securities regulatory scheme. It ensures knowledgeable regulation. It ensures the resources and assets necessary to have effective and wide-ranging regulation. The SEC's oversight role is equally critical, and it is that partnership together that makes it work.
Mr. POMEROY. Mr. Brodsky.
Mr. BRODSKY. I agree with my colleagues, Mr. Pomeroy.
Mr. POMEROY. We have worked together for years. I have enjoyed our working association. I was just fascinated by your testimony. I had no idea you weren't with the Merc anymore, and I didn't understand what you were saying.
Mr. BRODSKY. You weren't here when I started my testimony. I was actually on the securities side for almost 15 years before I went to the Merc. Now I am back on the securities side.
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Mr. POMEROY. Can you give me a 2-minute distinction between an option on a security and a future on a security? The chairman has indicated there will be a second panel so we will get to come around on some of these issues again, in the event you can't do it in about 90 seconds.
Mr. BRODSKY. I will do my best. I will also do this afterwards if you would like to do that. I think the most important distinction is an option, as derived from its Latin root which means ''to choose'' gives the holder the option of the right but not the obligation to buy or sell a security. The holder of a call can buy a security. The holder of a call has the right to sell a security. And the payment or premium that the person makes to buy a put or buy a call is the total risk of the transaction.
A future on a security puts the person who takes the futures contract at a much greater risk. It means that there is unlimited risk. If you sell a future on Exxon and the stock goes up 100 points, you will have 100 points of exposure.
There is a big difference between a futures contract in that sense and an option contract. They both can be used to hedge risk and do different things, but I think the most important thing is that option contracts tend to be used by retail customers much more than futures contracts in products because of the limited risk function of option ownership.
Mr. POMEROY. The Chair has indicated that I am the only one who wants to continue to ask questions of this panel and so rather than delay the second panel further, I would ask that each of you be available for questions that we might pose to you.
I thank you for your excellent testimony. I think the understanding of the distinctions between an option and a future on a security is a very fundamental issue that we have got to work our way through and that is going to be critical to make the policy judgments thereafter.
Thank you.
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Mr. EWING. Thank you, gentlemen. Sorry the bells interrupt, but that happens here at times. I appreciate your participation. I did want to mention that, Mr. Ketchum, you are in the article that Mr. Brodsky brought to our attention. So thank you again; and this will be, I am sure, one of several opportunities we will have to discuss these issues.
Thank you.
We will stand in recess for about 5 minutes and then we will have the next panel.
[Recess.]
Mr. EWING. I welcome the second panel to the table: Paul G. Kimball, managing director, Morgan Stanley Dean Witter, chairman of the Foreign Exchange Committee, representing the Foreign Exchange Committee; Ms. Jane Carlin, managing director, Morgan Stanley Dean Witter and chairperson of the Securities Industry Association OTC Derivatives Committee, representing the Securities Industry Association; Mr. Joseph Bauman, managing director, Bank of America representing International Swaps and Derivatives Association; Mr. Paul Saltzman, general counsel, The Bond Market Association; Mr. Kenneth M. Raisler, Sullivan & Cromwell, counsel to the Energy Group; Mr. Edward J. Rosen, Cleary, Gottlieb, Steen & Hamilton, counsel to the Ad Hoc Coalition of Commercial and Investment Banks.
Thank you all for coming. Thank you for participating again. Many of you have been in some of our prior meetings, so we welcome you back and look forward to your testimony here today.
We will start with you, Mr. Kimball.
STATEMENT OF PAUL KIMBALL, CHAIR, THE FOREIGN EXCHANGE COMMITTEE
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Mr. KIMBALL. Mr. Chairman, members of the subcommittee, I appreciate very much you giving me the opportunity of the Foreign Exchange Committee to comment on the deliberations for the CFTC authorization.
As way of background my name is Paul Kimball. I have been trading foreign exchange for the last 25 years. I am currently managing director of Morgan Stanley Dean Witter.
The Foreign Exchange Committee which I chair has been in operation since 1978. It is formed under the sponsorship of the Federal Reserve Bank of New York and it includes representatives of all the major international banks and brokers active in foreign exchange markets.
We have decades of experience not only in foreign exchange, but also in exchange-traded futures and other over-the-counter markets as well. I should tell you that I am also on the board of the Chicago Mercantile Exchange so I am very familiar with the role that both over-the-counter markets and listed markets have in the global financial marketplace.
My goal in my brief testimony is to give you a little sense of the benefits the over-the-counter foreign currency market is giving millions of Americans on a day-to-day basis and to caution all of us about any regulatory initiatives that could restrict those benefits.
As a way of background, the Foreign Exchange Market is a critical element in the functioning of the U.S. economy. I like to think of it as the glue that connects the U.S. economy to the global economy.
And the sheer breadth of users and suppliers of foreign currency services is really breathtaking. They range from agriculture firms that might be exporting crops, those same firms that may be importing farm tools, the export of computer software, foreign tourists who are coming to America for vacation, U.S. pension funds that are diversifying their portfolios of American savings into overseas securities markets, all these players and many, many more use the foreign currency markets.
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Now, as the global economies become more integrated, the pace of cross-border activity affecting the United States has only increased. Everything I see just says that that is going to continue to grow. The upshot is that the foreign over-the-counter foreign exchange market and the global foreign exchange market is an enormous financial business. In fact, it is the largest financial business in the world; $1 1/2 trillion a day in transactions goes through this market. Ninety-nine percent of that $1 1/2 trillion is going on in the over-the-counter market.
Now, one might ask, why is the over-the-counter market so much bigger than the listed markets? Well, whereas the futures, listed futures markets offer American users 18 currencies to trade four dates a year, the over-the-counter market can customize trades in up to 80 currencies that allow customers, users, to trade every legal working day of the year. So this customization aspect is of enormous benefits to the multiplicity of users that are out there, and it is that customization aspect we certainly don't want to see impacted by any legislation.
Now, as you can imagine, this global market with $1 1/2 trillion a day in turnover, it is very competitive because—I know that very well because I am up against the top financial institutions every day as I take on my trading and selling responsibilities in this business.
And that field has created probably the best transparency and lowest margins on entering and exiting the market of any financial product in the world. But that competition and that drive for efficiency has also led to some incredible technological innovation in the last several years. This invasion has allowed the automation of the critical aspects of foreign currency trading which is the trade execution where clients agree on the price, the trade clearing where clients and their dealer agree on where to pay the money, and then the settlement, which is the final banking operation that settles the transaction.
This competition and technological invasion has created an automation of these three activities to result in really an activity where these three mechanical parts of foreign exchange trade can be done seamlessly.
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So we are very concerned that any regulatory initiatives would try to redefine that technological invasion and create a way to bring that under the rubric of a more severe regulatory structure than we currently have.
Now, the other factor in our regulatory scheme that might change from where we are now is that this business could move offshore. People must realize that even though the foreign exchange market has a trillion and a half dollars a day in transactions, the U.S. component of that marketplace only handles 25 percent of the turnover. So there are many other centers in the world, London, Frankfurt, Hong Kong, Tokyo, that would be glad to pick up this business if the regulatory regimes changed in the United States and made this activity more restrictive.
Finally, I would like to say the over-the-counter market in foreign currencies has developed very well in the United States. It has grown just as much as the market has grown elsewhere in the world, and that is because we have had the protection of the Treasury amendment. This has allowed the foreign exchange market here to develop seamlessly and, as a result, we are very much in favor of maintaining this protection under the current regulation. The U.S. market, $400 billion of transactions are going through it every day so we certainly hope the intent of the Treasury amendment is maintained in any future legislation.
We, certainly, at the Foreign Exchange Committee support very much any regulation that would protect, certainly at the retail level, abuses that may go on in foreign currency bucket shops, and we would be glad to help the committee look at legislation in that regard.
In summary, I just want to leave you with really four points.
No. 1, we certainly on the over-the-counter side don't want the United States to lose its place in this very vibrant marketplace that provides enormous benefits to the U.S. consumer. We want American consumers not to pay any regulatory tax or have greater inefficiencies in their dealings in this market.
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We certainly don't want technological efficiency in the automation of the execution clearing and settlement process to create an open door for future regulatory burdens.
And finally the legal certainty the Treasury amendment gives is something we don't want to lose in any regulatory change.
I very much appreciate the chance to be here. It is the first time I have had this chance to testify, and I certainly stand ready with my committee to help in any way we can as you deal with this important issue.
Mr. EWING. Thank you, Mr. Kimball.
You did a very good job. Appreciate that.
[The prepared statement of Mr. Kimball appears at the conclusion of the hearing.]
Mr. EWING. Ms. Carlin
STATEMENT OF JANE CARLIN, CHAIRWOMAN, OVER-THE-COUNTER DERIVATIVE PRODUCTS COMMITTEE
Ms. CARLIN. It is also my first time so I hope I get the same compliment at the end.
Mr. EWING. If I forget, I tell you now.
Ms. CARLIN. Good morning, Chairman Ewing and members of the subcommittee. I am Jane Carlin, managing director at Morgan Stanley Dean Witter.
I have been involved in the industry, just by way of background, for 17 years. My role, if you will, in the industry is I advise on regulatory and legal issues regarding a wide range of investment transactions, and I think that is true of many of us on the panel that we have been involved in all of the products including stocks, bonds, foreign currency, commodities, futures, and derivatives.
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I am appearing before the subcommittee today in my role as chairwoman of the Over-the-Counter Derivative Products Committee of the Securities Industry Association. SIA expects to be actively involved with the Congress in shaping a modern and reinvigorated Commodity Exchange Act that is responsive to the need for legal certainty and innovation as we enter the next century.
Mr. Chairman, this, week Congressional Quarterly indicated that you have compared the CEA reauthorization debate to the 20-year stalemate over modernizing the laws governing financial services. I sincerely hope the stalemate part isn't true of the global markets. And our international competitors will not sit idly by while we sort out the CEA's anachronistic regulatory problems.
We do not have the luxury of risking the global competitive position of U.S. financial firms and of U.S. exchanges in a protracted legislative debate about how to resolve issues that have already been outstanding for many years. Reforms are needed now and are long overdue.
Since the modern CEA was enacted in 1974, the global economy has become increasingly more diverse, more internationalized, and, due to technological advances, the pace of economic change has become more rapid. As a result, real and substantial need exists for flexible tools to manage the varied, complicated, and quickly evolving financial risks faced by businesses throughout the world.
The history of the CEA evidences Congress's appreciation for the importance and benefits of OTC derivatives and hybrid products and it reflects Congress's recognition of the critical differences between futures and OTC products. But confusion about the precise scope of the CEA's regulatory coverage now subjects OTC derivatives and hybrid products to an intolerable degree of legal uncertainty which threatens existing products and outstanding contracts and impedes the development of new products.
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This legal uncertainty is particularly acute in the context of OTC derivatives and hybrid products based on non-exempt securities. The CEA has also impeded development and implementation of technological advances concerning the execution, clearing, and settlement of these products at a time when such innovations are sought to reduce systemic risks. There is something materially wrong with the regulatory scheme that continually and repeatedly jeopardizes otherwise lawful and socially desirable economic activity.
Over the years we have witnessed a counterproductive cycle wherein legal uncertainty arises and Congress eventually responds but not in a way which resolves the core structural problem with the CEA itself. Now the time has come for Congress to restore once and for all the legal certainty for swaps and hybrids that it intended to create both in 1974 and 1992, and to do so in a flexible manner that will encourage innovations both in OTC products themselves and the manner in which the OTC business is conducted.
To accomplish these legislative objectives, the SIA specifically recommends the following: First, Congress should amend the CEA to explicitly exclude swaps and hybrid instruments based on non-exempt securities. If there is one issue that the SIA would have the subcommittee address, it would be to correct this intolerable situation.
Second, Congress should codify the existing administrative exemptions for swaps and hybrid products to permanently exclude them from CEA regulation. In doing so, Congress should also provide flexibility in these exclusions to allow the evolution of new swaps and hybrid products and to permit clearing and electronic trading.
Third, Congress should clarify its original intent that the meaning of the term ''board of trade'' as requested in the Treasury amendment means organized exchange. And that the use of electronic trading or clearing mechanism does not entitle the CFTC to assert jurisdiction under the CEA.
And finally, Congress should not subject OTC derivatives dealers to regulation under the CEA.
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The SIA is mindful, Mr. Chairman, that this committee is deeply concerned about the safe and efficient operation of the physical commodities markets. This traditionally has been the primary concern of the CFTC. In our view, to change the mission of the CFTC to cover the length and breadth of the OTC derivatives markets would not only present duplicative regulatory requirements but also overwhelm the traditional mission of the CFTC. We instead recommend that you consider amendments which will provide the necessary legal certainty and eliminate barriers to innovation which today prevent our financial sector from moving forward.
Mr. Chairman, as the saying goes, we need to lead, follow, or get out of the way. SIA asks for your leadership and that of the committee to reform the CEA and allow our financial markets to continue to be the envy of the world.
Mr. Chairman, thank you for the opportunity to testify on these important issues today. The SIA looks forward to working with you and the Agriculture Committee to appropriately address these critical issues this Congress. And I would be happy to answer any questions.
Mr. EWING. Thank you for a good job.
[The prepared statement of Ms. Carlin appears at the conclusion of the hearing.]
Mr. EWING. Mr. Bauman
STATEMENT OF JOSEPH B. BAUMAN, MANAGING DIRECTOR, BANK OF AMERICA, REPRESENTING THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
Mr. BAUMAN. Thank you, Mr. Chairman.
Chairman Ewing and members of the subcommittee, I am Joseph Bauman, managing director of the Bank of America. I am here today representing the International Swaps and Derivatives Association which is widely known as ISDA.
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My firm is a member, and I am a former chairman of ISDA. ISDA is an international organization, and its more than 400 members include most of the world's primary dealers in principal-to-principal derivatives transactions and many of the businesses and governmental entities that use these transactions as an integral part of their risk management activities. In addition, our members are among the principal customers of the regulated futures exchanges.
I had the pleasure of appearing before the subcommittee last year in connection with your review of the CFTC's concept release on derivatives instruments, and let me say at the outset, Mr. Chairman, that we appreciate both your continuing commitment to modernizing the Commodity Exchange Act and your leadership in 1998 in connection with the standstill legislation enacted to preserve the regulatory status quo and market stability so that Congress itself could consider and resolve the important public policy issues here.
As you know, Mr. Chairman, ISDA has worked with the subcommittee on these issues for more than a decade and in this brief oral statement, I will summarize ISDA's views on several of the key issues that are of direct importance to our membership.
In broad policy terms, ISDA believes that the Commodity Exchange Act should be modernized to provide legal and regulatory certainty for financial contracts, to encourage financial innovation, and to facilitate competition in the United States and abroad. A modernized CEA should foster efficient, liquid, and low-cost financial transactions not by limiting the alternatives available to firms desiring to manage their financial and operating risks but by promoting alternative paths each within an appropriate legal and regulatory structure.
Regulatory burdens that increase the cost or reduce the availability of essential risk management tools to America's businesses and other end-users should be imposed only in those cases where less burdensome means, including market discipline, have not been effective.
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There are a number of specific actions that Congress should take to achieve these broad policy goals. First, Congress should clarify once and for all that the Commodity Exchange Act does not apply to principal-to-principal derivatives transactions.
In addition, regulatory relief should be provided to the organized futures exchanges to the maximum extent Congress concludes it is prudent to do so. ISDA and its members would welcome legislation that modernizes exchange regulation, increases the autonomy of the exchanges, and enables them to more promptly to offer a broad array of risk management products.
Let me devote the remainder of my remarks, Mr. Chairman, to the critical issue of legal certainty for principal-to-principal derivative transactions. For simplicity, I will refer in the balance of my testimony to these transactions collectively as swaps transactions.
As explained more fully in our written statement, swaps are powerful tools that enable America's businesses to manage the risks that are inherent in their core activities, lower their cost of capital, and manage credit exposures and increase their competitiveness both here and abroad. Swap transactions are fundamentally different than exchange-traded futures contracts. One of the important differences is that the key economic terms of a swap transaction can be tailored to meet the specific risk management needs of each end-user, and it is this almost limitless flexibility that has led to the growth in the volume of these non-exchange risk management transactions.
Any uncertainty with respect to the enforceability of swap transactions obviously presents a significant source of risk to the individual parties to those transactions. More importantly, any such uncertainty creates risks for the financial markets as a whole and precludes the full realization of the powerful benefits that swap transactions provide.
Our concerns about the impact of regulatory actions under the CEA on the enforceability of swap transactions are neither academic nor speculative. In 1998, unilateral actions by the CFTC suggested that the CFTC might treat certain swap transactions as futures contracts. And the suggestion nearly shattered the settled expectations of the financial markets that swap transactions were enforceable in accordance with their terms.
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The CFTC's actions demonstrated conclusively that legal certainty and market stability can be undermined regardless of the CFTC's intentions in pursuing a particular course of regulatory or enforcement action.
The experiences we shared in 1998 confirmed that, as we have known for years, the heart of the problem is in the structure of the CEA itself. This means that legal certainty issues cannot be clarified with the necessary finality except by the action of Congress.
There are several frameworks within which Congress could clarify that the CEA does not apply to swap transactions. These range from a complete restructuring of the act to a more targeted and incremental approach to reform involving the clarification and expansion of exclusions. Each of these reform frameworks could readily accommodate broad regulatory relief for the organized futures exchanges.
But whatever reform framework the Congress chooses, Mr. Chairman, legal certainty should have four components.
First, Congress should clarify that the CEA does not apply to swaps themselves. This legal certainty should be extended to all forms of swap transactions including those based on securities prices and not just the transactions referred to in the so-called Treasury amendment.
Second, the Treasury amendment should be clarified in certain respects to assure continued enforceability of swaps involving Government securities and foreign currencies.
Third, the broad scope of the CFTC's 1998 proposed concept release underscores the need to assure that statutory provisions enacted by Congress to establish legal certainty cannot be used to impose non-legislative regulatory burdens on these transactions or participants in them.
And finally, as part of the legal certainty agenda, Congress needs to address questions related to emerging electronic technologies so that we will not shortly find ourselves enmeshed in another round of legal and regulatory uncertainty that will inevitably deter financial innovation and improvements in risk management.
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Each of these four points is developed more fully in our written statement.
Let me conclude, Mr. Chairman, by emphasizing once again that ISDA remains committed to working with the subcommittee on a cooperative basis to assure that the key reform objectives of legal certainty for swap transactions and regulatory relief for the organized exchanges are translated into legislative realities in this Congress.
Thank you, Mr. Chairman, and I would be pleased to answer any questions that you or the members of the subcommittee have.
[The prepared statement of Mr. Bauman appears at the conclusion of the hearing.]
Mr. EWING. Thank you. Mr. Saltzman.
STATEMENT OF PAUL SALTZMAN, GENERAL COUNSEL, THE BOND MARKET ASSOCIATION
Mr. SALTZMAN. Good morning, Mr. Chairman.
Good morning, Chairman Ewing and members of the subcommittee. My name is Paul Saltzman, and I am senior vice-president and general counsel of the Bond Market Association, the trade association that represents firms active in our Nation's and the global bond markets.
Although we have an interest in the over-the-counter derivatives markets because of the interplay between these markets and the cash bond markets, I will focus this morning on the Treasury amendment, on the Treasury amendment's exclusion for over-the-counter Government securities transactions from the provisions of the Commodities Exchange Act.
This exclusion from the Commodities Exchange Act is entirely appropriate and necessary for two reasons.
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First, the over-the-counter Government securities markets is thoroughly and adequately regulated under a separate legal structure.
And second, the time-tested balanced approach to regulation in the Government securities markets has allowed the market to serve American taxpayers well by keeping borrowing costs low as possible for the Federal Government. Duplicative or overly burdensome regulation would hinder market functions and increase the borrowing costs for all American taxpayers.
We should be clear about the Government securities market. The Government securities market is the world's most efficient and liquid market. It is the benchmark and engine for the global capital markets. Each week the Treasury Department borrows from investors to meet our Nation's short-term financing needs. On numerous occasions throughout the year, Treasury issues securities with long maturities some now which are creatively designed to minimize the impact of inflation. In addition to the Treasury Department, other Government-sponsored agencies routinely access the debt-capital markets to finance important public policy missions sanctioned by this Congress. Ginnie Mae, Fannie Mae, Freddie Mac, for example, take advantage of the Government securities markets to raise capital and help reduce the borrowing costs for home ownership.
The farm credit system, the Small Business Administration, and the Tennessee Valley Authority all provide valuable support for the secondary market and important economic sectors of our country's capital markets.
The capital raised in the Government securities market is literally put to use throughout the economy and touches the lives of every American. Our member firms have helped Governments and organizations borrow at the lowest possible cost by ensuring the existence of an active and safe Government securities markets that literally operates 24 hours a day around the world. In fact, firms designated as so-called primary dealers by the Federal Reserve Bank of New York engage in daily trading volume that averages more than $225 billion a day in Treasury securities alone.
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This massive volume of market activity is augmented by a number of transactions such as futures, forwards, swaps, and options, hence the interrelationship that I mentioned at the outset of my remarks. It also involves a unique set of practices and procedures. In the Treasury auction, for example, trading activity on a given security actually begins a week before issuance in the so-called when-issued market.
In addition, market participants fund their activity through trading activities characterized by repurchase agreements which involve the sale of securities to another party with a corresponding agreement to buy them back plus an additional amount. But for the Treasury amendment, these and other Government securities transactions could very well be subject to the Commodities Exchange Act creating legal uncertainty for billions of dollars of transactions.
The massive amount of activity in the Government securities market occurs, Mr. Chairman and members of this committee, under a carefully designed regulatory regime that helps ensure the safety, soundness, and enforceability of obligations.
Since 1934, the Securities and Exchange Commission has had antifraud authority over the Government's securities markets. In 1986, and again in 1993, Congress enacted the Government Securities Act and subsequent amendments specifically designed to maintain the integrity of this vital marketplace.
Today, the regulatory capabilities of various organizations and Federal agencies are combined with highly effective voluntary industry initiatives to bolster transparency, confidence, and efficiency in this Government securities markets. The Treasury Department has permanent rulemaking authority in this market and requires reporting of large positions.
All Government securities, brokers, and dealers must furnish transaction records to the SEC on request. The NASD and bank regulators aggressively set sales practice rules for Government securities dealers. Clearing corporations are adequately regulated by the SEC and as stated by the SEC, the Federal Reserve Board and the Treasury Department in a 1998 report to this Congress, no additional rule-making authority is required at this time in the Government securities market.
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In other words, there is no regulatory gap and, except with respect to transactions on designated contract markets, the CEA has absolutely no role to play in the regulation of the Government securities markets without creating redundancy, reducing market liquidity, and increasing costs.
Turning to the specific language of the Treasury amendment we urge that this exclusion be amended to clarify that over-the-counter transactions in or in any way involving Government securities are picked up. Such language would be consistent with the Supreme Court's decision in Dunn and would eliminate any remaining legal uncertainty about the scope of the Treasury amendment's exclusion.
We also urge that the Treasury amendments term ''board of trade'' be clarified. All Government securities trading activities should be excluded from the CEA unless it occurs on a designated contract market that is registered as such with the CFTC. All exchange transactions in Government securities market are already appropriately regulated.
Mr. Chairman, thank you very much for the opportunity to appear before your subcommittee this morning. The Bond Market Association looks forward to working with you and your staff during this arduous reauthorization process.
I would be happy to answer any questions you might have. Thank you.
Mr. EWING. Thank you.
[The prepared statement of Mr. Saltzman appears at the conclusion of the hearing.]
Mr. EWING. Mr. Raisler.
STATEMENT OF KENNETH M. RAISLER, SULLIVAN & CROMWELL, COUNSEL TO THE ENERGY GROUP
Mr. RAISLER. Thank you, Mr. Chairman.
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Mr. Chairman and members of the committee, I am Kenneth Raisler with the law firm of Sullivan & Cromwell. I am here today on behalf of the Energy Group, a group of energy companies who are interested in the Commodity Exchange Act and the reauthorization process that this committee is undertaking.
The Energy Group members include producers, processors, merchants, and others who are involved in the natural gas and oil businesses as well as electric utilities and marketers of electricity.
In their everyday business, the members of the Energy Group are actively involved in a full range of derivative products, including futures as well as OTC derivatives. Members of the Energy Gropu use derivatives for their own risk management purposes. They also market derivatives to their customers as part of a full range of risk management services.
Members of the Energy Group have had a long-term interest in the Commodity Futures Trading Commission and have been involved in the reauthorization process on Capitol Hill for over a decade.
Our concerns going into the CFTC reauthorization are effectively threefold.
First, we are interested in legal certainty for the OTC derivative contracts involving energy products. We echo the sentiments of Mr. Chairman in your opening remarks in indicating that one of the key priorities for reauthorization has to be greater legal certainty for OTC derivative products, and our remarks are also echoed by the other members of this panel.
In contrast to other members of this panel, however, many of the members of the Energy Group and also the customers that we serve are U.S. companies that do not wish to and do not currently have oversees affiliates through whom they can do OTC derivatives business. The result of legal uncertainty and, in particular, increased legal uncertainty that could come out of the CFTC is that many members of the energy community would not be able to take advantage of these important risk management tools which are now essential to their everyday business. They could not effectively take their business offshore and they would be deprived of these important services.
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Second, we oppose any initiative to regulate OTC energy derivatives dealers. Over the last decade, there has been enormous growth in energy derivatives trading. This growth has occurred without incident and without complaint. We believe there is no justification for imposing regulation on derivatives dealers.
Certainly derivatives dealer regulation by the CFTC and the imposition of such regulation would only increase the cost and discourage people from participating in the business which would have negative effects not just on the dealer community but on all the energy companies who could take advantage of and benefit from energy derivatives dealings.
Third, we seek legal certainty for electronic trading systems for energy products. There has been a growth outside of the United States of a variety of electronic systems to deliver energy products and to promote energy trading. We seek to allow those products to be offered and sold in the United States through electronic trading mechanisms. At the present time ambiguities that exist in the Commodity Exchange Act discourage companies from offering those products and we seek, through this reauthorization process and by working with the CFTC, greater legal certainty with respect to that activity.
Thank you, Mr. Chairman, for the opportunity to present our testimony to this committee.
We, too, stand ready to assist this committee throughout the reauthorization process and are committed to helping in any way that we can.
Of course, I am prepared on behalf of the Energy Group to answer any questions that the committee may have.
Thank you.
Mr. EWING. Thank you very much.
[The prepared statement of Mr. Raisler appears at the conclusion of the hearing.]
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Mr. EWING. Mr. Rosen
STATEMENT OF EDWARD J. ROSEN; CLEARY, GOTTLIEB, STEEN & HAMILTON, COUNSEL TO THE AD HOC COALITION OF COMMERCIAL AND INVESTMENT BANKS
Mr. ROSEN. Thank you, Mr. Chairman.
The coalition of firms that I represent here today are participants in all of the major U.S. and foreign financial markets—the cash markets, the securities markets, the futures markets, and the OTC derivative markets.
They are members on all the trade associations that you have heard from. They are major participants in all of the exchanges that you have heard testimony from. The future exchanges and the securities exchanges and really no constituency has a greater stake in the issues that are before this subcommittee than that group but also this group has as broad a consensus and perspective on the issues that face this committee in this reauthorization.
I don't want to testify here this morning about the details. I think you have heard a lot about the details over the course of the past few days. I want to focus on the need because the need is great and the need for action by this subcommittee is great.
The issues that we face are not just issues for the financial institutions that you have heard from. These are issues that affect the entire spectrum of the U.S. economy, the industrial belt, the agriculture belt, silicon valley, Wall Street, La Salle street, and main street. These are matters that affect not just the U.S. economy but also our global financial position as a leader.
Today the Commodity Exchange Act is a statute that has become badly out of sync with the markets that it governs and it casts a very long shadow over activities that it was never intended to govern. It has become a real legislative irony.
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I imagine if your constituents asked you what is the purpose of legislation, you would say, well, to make the market a safer place to address some of the risks that are associated with regulated activity. We have to understand and come to grips with the fact that today the CEA creates risks that would not otherwise exist and stands as an obstacle to private sector initiatives to mitigate the risks that companies in all sectors of the economy face because of the nature of our free-market economy.
We have attempted for 10 years to address these issues. In 1992, we were able to make some progress but still progress born in compromise. In 1987, we failed entirely to make progress. In 1998, we had what a lot of people regard as a near death experience averted in large part only by the efforts of the members of this subcommittee and some of your colleagues for which we are very appreciative.
The failure to address these issues of legal uncertainty often has very little to do with the merits of the issues. What has happened in the past is that, frequently, legal certainty has become a bargaining chip. It has become a bargaining chip in a process to obtain other legislative concessions, and this is a strategy with which we can no longer tolerate.
These issues must be addressed individually on their individual merits. We cannot let progress on these legal issues be held hostage. If this Congress cannot solve any issue unless it solves every issue for every constituency, we have a recipe not only for regulatory gridlock but significant market erosion.
A lot has been made of the parity issue. The exchanges are regulated. The off-exchange market is not regulated. I think the case has been made quite forcefully that the success of the OTC market lies in the ability of these products to address specific needs, their flexibility, their ease of execution.
Within that market there are a broad spectrum of participants, some of whom are far more regulated than any exchange who compete with others that are either unregulated or less regulated and that degree of regulation has not really been an issue. I want to make it clear that that should not in any way be taken as suggesting that this committee should not provide regulatory relief to the exchanges. We think it is absolutely appropriate for this subcommittee to evaluate the impact of this regime on the futures exchanges and determine what is necessary and appropriate relief for them.
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But there are many reforms in this debate and some of them are as complex and controversial issues. The solution to legal uncertainty, however, is clear and we must take the straightforward steps that are necessary to address it. And we can no longer afford to take the risks that are associated with inaction.
We cannot permit the CEA to remain an obstacle to the implementation of new technologies and risk reducing mechanisms in the private sector. We cannot allow it to continue as a catalyst to the slow migration of financial services to foreign financial centers.
The more outdated this statute is permitted to become, the greater the likelihood that ultimately it will become irrelevant. If we miss opportunities to modernize the CEA, the United States will not only put at risk its position as a leading financial center but this Congress and the U.S. regulatory committee will significantly diminish their own influence over the development of regulatory policy in a world which we acknowledge is growing internationally and in which the challenges arise from the need to obtain or achieve coordination on an international dimension.
We very much appreciate the subcommittee's interest in these issues, and we look forward to working with the committee on these issues. But I would like to leave you, if I may, with a very short story.
In the 1960's, Congress imposed a flat 30 percent tax on interest payments to non-U.S. bond holders. Well, the market voted with its feet; and in the 1960's, issuers of bonds moved to London to issue bonds that would not be subject to the withholding tax so that it would increase the yield to investors and reduce the cost of issuing debt to issuers that took advantage of this fact. They created what has been called the Eurobond market.
In 1984, Congress came to the realization that that tax which was supposed to be a revenue measure was instead a deficit measure. It significantly reduced tax revenues and in 1984 in the Deficit Reduction Act, Congress moved to repeal that act and replaced it with portfolio interest provisions.
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The more interesting thing, though, is that today, 15 years later, that market exists in London; and it is the largest international capital market in the world. Its currency is dollars, and it is located in London.
We cannot afford to compound that problem and the real difference between that situation and this situation today is that what—the situation we created then by what might have been regarded as imprudent action is a risk that today we create by our inaction.
The time has come for us to address these issues. They are difficult issues, but we very much appreciate and urge this subcommittee's efforts to address them once and for all.
Thank you, Mr. Chairman.
Mr. EWING. Thank you.
[The prepared statement of Mr. Rosen appears at the conclusion of the hearing.]
Mr. EWING. I don't want to leave the impression that I think everything that breathes, walks, talks, moves should be regulated, but I would like for those of you who you have a variety of different products to tell me what products that you deal with are not regulated. We won't keep notes. Of course it is on the record.
Mr. BAUMAN. I will start, Mr. Chairman. As a representative not only of ISDA but as an employee of a commercial bank, I view the question not so much as what products are regulated or not regulated but the fact that our institution is regulated across all of its products and is subject to the regulation and supervision of the bank regulators who regularly examine those activities.
The benefit of that we feel is that it gives a broad spectrum view of how we use our various products with our clients and for our own activities in a light that does not isolate on specific product elements.
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My answer to your question would be in a certain way all of our activities are being regulated today.
Mr. EWING. Probably it would maybe help you understand that I am trying to understand. And I recently had a very enjoyable trip to New York and I visited with the Stock Exchange and I visited with the Federal Reserve and I visited with the bankers and some of you people here in the audience.
And different people were telling me who was regulated and who wasn't regulated and I—at the end of the day, I had gone in one great big circle. And I think that Mr. Bauman makes the point there that some of the things that you deal with at the banking level you consider regulated under the general banking regulations of this country, not specifically regulated like products on the futures exchange or stocks on the stock exchange.
Is that correct?
Mr. BAUMAN. Yes. Of course there are parts of our activities, such as our activities in the futures markets which are subject to product regulation as well. It is not that we are exclusively regulated by the bank regulators.
Mr. EWING. It depends on the product?
Mr. BAUMAN. Yes.
Mr. EWING. What I am trying to get at here is that we talk about over-the-counter market and the tremendous growth in this market and the volatility of it and the importance of it and yet those of you who deal in that, is that regulated directly, indirectly? Maybe that is the question.
Mr. KIMBALL. On the foreign exchange side, it is really regulated indirectly in that the institutions that are primary dealers in those markets are regulated by some authority within their country. So their positions are monitored.
There is capital requirements against the different foreign exchange positions. I can speak to that market. But exactly how one deals with one's counterparty in terms of creating a transaction, settling it and clearing it, that is not subject to regulation. That is subject to the self-policing that institutions and organizations like the Foreign Exchange Committee and others have set up in order to not allow any chaos and any undue legal or credit risk to seep into that process because the sums of money are enormous. But so far that indirect regulatory scheme has worked exceptionally well because the market has grown.
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There have been few, if any, abuses that in any way have affected the functioning of the market. And, at the same time, institutions cannot put either themselves or the system at risk by undue concentration of risk certainly in the foreign exchange area because if they do, they have to have capital against it and there are prudential rules within organizations about how much capital can be committed to any activity.
So, hopefully, that gives you a flavor for how it works in the over-the-counter domain.
Mr. EWING. And those rules are promulgated by?
Mr. KIMBALL. The capital rules, for example for investment banks, the SEC, and then for the commercial banks would be the Federal Reserve. And of course what's interesting is that—and this, I think, has been an incredibly healthy development.
The BIS, the Bank for International Settlements, is trying to get some commonality in the rules across the major countries so that one country's institutions doesn't engage in the markets. And, in a way, that is very much different than the sort of ground rules that one finds in any country.
So that means that G–7, G–10 arena is becoming much more level, and it is probably the reason why we haven't had any dramatic systemic blowups along the way. So that has been a very positive development to see the global community embrace some commonality of capital standards for risks that are taken in these over-the-counter markets.
Mr. EWING. Ms. Carlin.
Ms. CARLIN. I would add just two thoughts on this.
One just picking up on Joe Bauman's point because I think you can make the same point for investment banks like Morgan Stanley Dean Witter. We are regulated in varying degrees with respect to virtually everything we do. So, as an example, you are probably familiar with the SEC's risk assessment rules which require that we report material risks taken on by material affiliates even in connection with unregulated products. So it is difficult to be quite so black and white about the issue.
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Separately, let's remember that regulation varies. And I could give you many examples, even within a single product. So even in instances where products themselves are directly regulated, and I could use as an example the margin area which has obviously been talked about a lot earlier today. The New York Stock Exchange's own rules vary in terms of what a margin requirement might be depending upon who you are transacting with.
So, as an example, certain Government securities transactions are entirely free of margin requirements because the exchange in their self-regulatory capacity determined that certain large customers do not need to post margin in those transactions. So again I think any point would be it is more complicated than creating a list of this is regulated and this is unregulated.
There is not only a lot of overlap but a lot of variability within a single product.
Mr. EWING. And under the Commodities Exchange Act, the over-the-counter market has been generally exempted from their regulation so your regulation—if there is regulation in that market, it comes from other areas from the banks.
Mr. BAUMAN. Yes, that is right, Mr. Chairman. The 1993 exemption basically said that over-the-counter transactions would not be generally subject to the CEA except in specific circumstances of antifraud and manipulation.
But I think the key point here is that whatever that regulatory environment is, what we are speaking of, I think unanimously, is the question of a legal certainty with which the contracts can be enforced. And regulatory issues are related to that, but our key concern is really one of legal certainty in that environment.
Mr. EWING. I am tying to get somewhere else with this line of questioning, but I understand that the legal certainty of the contracts that you enter into is extremely important and you don't want that jeopardized in the middle of a contract or at all. That you can't have that.
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The futures exchanges hedge risk—many of the contracts you are talking about are to also hedge risk?
Mr. KIMBALL. That is exactly right. For example the over-the-counter foreign currency market, there are needs in several currencies around the world each day—each day for settlement purposes and generally futures exchanges in the currency area around the world have had limited settlement provisions.
They have had limited settlement facilities. That is because they are set up to really provide price and hedging risk facilities for participants. But there are just a multitude of needs around the world to buy and sell goods, services, invest money abroad, and then to settle those transactions on any number of days during the year not only this year but several years out.
For example, in the over-the-counter market, you can do a trade in the dollar versus the Euro for a 10-year delivery, and that kind of customization just matches up with this global world and economy that we are finding ourselves where the breadth of transactions that cross borders are hard to even enumerate.
Mr. RAISLER. On behalf of the Energy Group, I would like to respond to your question.
I think, for the record, the Energy Group is essentially unregulated in its OTC derivatives dealings. Of course, to the extent the Energy Group members participate in U.S. futures exchanges, they deal through futures brokers, and the regulated environment there. And to the extent that they are customers of energy derivatives dealers, they, like any other customer, are essentially unregulated.
But in addition, as dealers in the energy market, they are not regulated. Derivatives dealing is, from their point of view, part of the services that they are providing either as buyers or sellers of oil or gas or electricity. They are providing risk management services or buying and exchanging risk management services with their customer community and, at the present time, they remain unregulated and proud of it.
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I think there is no basis whatever established in or any evidence of any kind I have seen that supports the need for regulation or the benefits of regulation. In fact, the activities that they have engaged in have only grown over the last decade without incident or complaint and, as a result, we feel strongly the status quo of unregulated activity should remain.
Mr. ROSEN. I think I understand the issue that you are trying to grapple with, and I think the answer to your question it is a very mixed bag. Agriculture forwards, very important product—it is not regulated in this country. OTC's securities transactions generally regulated—generally quite heavily regulated and even differences, as Jane pointed out, depending upon what the nature of the transaction is.
Mr. EWING. Did you say agriculture is not regulated?
Mr. ROSEN. Some are regulated. Some are regulated to different degrees than others and some because of the nature of the way they are conducted or who they are between or other circumstances affecting the transaction may not be subject to particular regulations.
The market generally, though, is conducted by very sophisticated institutions who deal with very sophisticated counterparties, counterparties who have a commercial need. That was really the basis originally for the Commodity Exchange Act to exclude from the Commodity Exchange Act agriculture forward trading.
It turned out to be a market which by and large—every market has its slips and turns which was not in need of Federal regulation. The perception that Federal regulation of that market would be counterproductive. I think what we would say to you is that although there is an uneven landscape in terms of the degree of regulation, that is in some senses a healthy thing.
There is a great degree of private market discipline in that market. This is not a market which has evidenced widespread abuses when there have been events which, in my view, are relatively few. When you take into account the enormous size of these markets, the incidents are generally quite few. Those have generally involved situations where people took on too much risk, where people tried to execute a very aggressive strategy and lost a lot of money and have learned their lessons.
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And I think even the events of last year indicate that the real issues there are the adequacy of prudential measures from managing credit risk which is something that the markets are going to come to terms with as they evolve and mature, but 90 percent, I think, or more of the OTC markets talking in broad terms are, in fact, actually conducted by dealers who are either directly or indirectly regulated by Federal or State regulators or our affiliates or are participating in some scheme like the derivatives policy group framework in which they have agreed to make things available on a voluntary basis for the sake of demonstrating that there are not systemic risks emmanating from their activities.
Mr. EWING. Many of you deal with the organized exchanges, and I get this vision that we have in America, in the country, the organized exchanges which—certainly don't mean this is any insult to them, more like a Model T plugging along with all of the rules and regulations they have had for decades alongside of this new very lively and growing market, the over-the-counter market which is operating on a very new mechanism that is not hampered with regulation at the same degree certainly as the other. And you move into the old when it suits you and into the new when it suits you, and we are talking about the regulatory scheme here that particularly describes the old. And they are saying let us out of this box. Let us get out there and compete. We see our market moving off down the road at a bigger clip. Is that a fair analysis?
Mr. ROSEN. I would say it is a fair but partial
analysis.
Mr. EWING. I am totally impartial.
Mr. ROSEN. I didn't mean partial in that sense, I mean not the complete picture.
We agree that there are respects in which the exchanges need to be able to participate more dynamically, more flexibly, be responsive to and be able to execute business objectives. We wholeheartedly support that.
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But there is also a sense in which what you have here is the market evolving. You have to understand that the exchanges evolved in an environment in which there was not electronic communications, there was not vibrant cash market trading. The exchanges were where you went to create liquidity, discover what prices were, and to get a liquid market.
As a physical presence they accomplished a need that was very important for the physical commodity markets. What the OTC markets do is address more customized and specific needs but also have been more aggressive in trying to take advantage of technological developments which enable the OTC market to accomplish things that previously could only be accomplished on a futures exchange.
Now, there are advantages and disadvantages to each. Some of them are product specific. Some of them are not. What I think we all want to accomplish is to be able to operate our businesses in a way that enables us to be the most responsive to our clients because ultimately client demand is what drives this business and the OTC markets have been extremely successful in accomplishing that.
The exchanges will be successful when they alight on their strategy for accomplishing the same objective in figuring out how, in the modern world, they are going to meet the demands of the American commodity economy in a way that is going to increase their volume. That is their challenge, and we agree the regulation should get out of the way.
Mr. EWING. My time is up. Mr. Condit.
Mr. CONDIT. Thank you, Mr. Chairman.
Let me say to the panel that I think you all did an excellent job. I particularly want to thank those of you who were specific in the things that you thought this committee and Congress should do.
I think that is very important for us. As a matter of fact, I was getting to the point where I thought I was understanding your testimony, and then it faded on me a little bit. But you did an excellent job.
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I want to followup with just a couple of quick questions to Mr. Kimball. If I understand this correctly, you ask for less CFTC regulation over U.S. involvement in foreign markets. Should Congress grant any means for the CFTC to have oversight to protect U.S. interests or international regulatory agencies providing a fair playing field?
Mr. KIMBALL. I think the key is that where the over-the-counter market currently sits on the foreign currency side in the United States is actually in a good place, and what we don't want is for the CFTC to gain oversight over that market.
The Treasury amendment right now exempts the activities in this market from CFTC regulation; and if you look at the success of the over-the-counter market, the U.S. proportion of the global foreign exchange market which is very representative of our share of the world's GDP, you can see that the over-the-counter market in the United States is functioning very, very well. So we want that legal certainty to remain so that that over-the-counter piece of the foreign exchange market continues to grow in the United States and all the benefits that Americans are getting from this customization which flows very naturally.
We don't want that to be changed, and I think parts of the regulatory proposals that are out there would change that and so the status quo as it were where we are now is allowing this enormous foreign exchange marketplace of a trillion and a half dollars a day, it is allowing the United States to get its fair share of it, and so we want to see that continue to evolve as it is.
Mr. CONDIT. So my first statement that you felt we should have less regulation, you think what we have got is acceptable; is that right?
Mr. KIMBAL. For the over-the-counter activities, yes. Now, we would be happy to talk to you about the listed—the futures exchanges. There probably are some issues there. But for the over-the-counter market, it has the exemptive sort of jurisdiction with which to operate that has allowed it to flourish.
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Mr. CONDIT. Thank you.
Mr. Saltzman, one debate has been how to classify electronic transaction as public or private markets. How would you classify them and more importantly, what specific regulatory oversight should CFTC provide if any?
Mr. SALTZMAN. The question of how to define an organized exchange I think is very complex and certainly technology and electronic trading has created all sorts of definitional issues. I think certain electronic trading facilities have the attributes of an organized exchange, certain electronic trading facilities don't.
Again, I think from the perspective of the Bond Market Association and for the specific purposes of the Treasury amendment, we would like to see the term ''board of trade'' clarified to essentially mean a designated contract market. Again, the notion is that you focus on the trading venue.
If someone buys a Treasury bond future on the Chicago Board of Trade, that should be regulated by the CFTC. If someone purchases a Treasury security on a forward basis in the over-the-counter from Morgan Stanley or Merrill Lynch that should be regulated essentially by the Securities and Exchange Commission as it currently is.
If there is an electronic trading facility that effectively is an efficient means for Morgan Stanley to effectuate that transaction, it seems to me that is not an exchange. The key attribute of an exchange—and it is not a physical floor, clearly we know that, are expectations of liquidity and certain other protections that are the hallmark of a combined clearing function—for example, so if all you have is an electronic trading facility that merely brings a buyer and a seller together, it would seem to me that would fall outside, should fall outside of the jurisdiction of the CFTC.
Mr. CONDIT. Thank you.
Let me see if I can sneak this in to Ms. Carlin before my time runs up. One of the concerns that I think you expressed yourself and I know other stakeholders involved in the CEA has expressed limiting U.S. competitiveness in global markets.
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Can you give some example of your concerns that legal uncertainty has moved OTC activities offshore and inhibited innovation?
Ms. CARLIN. I wish I could tell you that I couldn't come up with an example, but unfortunately I frankly have a bunch in mind.
The category of transactions that I would highlight for you are really the transactions that are now confusingly maybe sitting between securities and commodities regulation, and I will give you an example.
If we were to engage in a swap transaction which we felt was currently vulnerable to regulation from a CFTC perspective because—imagine it is a swap involving a non-exempt security that is sitting outside of the existing CFTC exemption. Frankly, we would probably conduct that transaction through a foreign affiliate because we would not want to take the legal risk associated with conducting a transaction that we think is fine. Frankly, we know is fine. But in light of last year's concept release and near-death experience kind of event you just don't know definitively. And that is why the certainty point keeps coming up in everyone's sentences, and it is really those products that, in some cases, someone has alleged might be subject to regulation by the CFTC that, as a lawyer and as an advisor to Morgan Stanley Dean Witter—obviously I am charged with protecting the firm from unnecessary legal risk.
I do not advise that that kind of transaction be conducted on shore today and that is really a shame.
Mr. EWING. Mr. Lucas.
Mr. LUCAS. Thank you, Mr. Chairman. Sort of for the benefit of my background, Ms. Carlin, if you could expand for a moment the OTC derivatives which involve retail transactions with individual investors, is it more appropriate to say that they could better be described as exclusively affecting institutional markets or is it better to describe them as transactions of retail investors in their general nature?
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Ms. CARLIN. My experience has certainly been that these are largely institutional marketplaces.
Picking up on an earlier, we can't broad brush all of these products in one bucket because they differ. So that equity derivatives have a different client-base, if you will, than interest rate products than foreign currency products than commodity products. I would point out that there is some component of what I will call, because this is what my institution calls it, high net-worth retail activity in the OTC derivatives marketplace.
You will see people like Bill Gates engaging in OTC derivatives activity; and, of course, we all know that he may have more money than many of the institutions we transact with. That probably has its greatest application in the context of equity derivatives when you look at the enormous stock holdings that some individuals like Mr. Gates may have. They need risk management tools to hedge and manage the risks associated with these large, in this case, equity portfolios.
Mr. LUCAS. In the general sense, of course, we tend to think of the institutional entity as being better prepared to take care of itself. From the general public's perception, the individual investor, the little man or woman out there—you mentioned the superinvestor, it is fair to say the superinvestor that I suppose limited group that falls in that category have the resources, the capacity to defend themselves more along the lines of an institution as opposed to J.Q. Public?
Ms. CARLIN. And, in fact, 99 percent of the time, they have already obtained professional advisors and money managers who are the common, frankly, institutional money management names you see around to, in fact, advise them as to the appropriateness and the utility of a variety of transactions.
Mr. LUCAS. Mr. Rosen, in his comments, gave a very graphic description of an act of Congress in the 1960's that had an impact which apparently Congress, in the 1980's, attempted to modify, and the course of action was taken. And following along on my colleague, Mr. Condit's question, are there any examples of this nature that are that dramatic, that graphic, or literally by action we have created a market somewhere else around the world the way Mr. Rosen described that particular type of bond market in London?
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Mr. ROSEN. It is actually—something similar to that actually did happen in the late 1980's when the CFTC first began to grapple with these issues.
An earlier administration issued an advanced notice of proposed rule making in which they suggested that certain kinds of swaps might be subject to and certain kinds of forward trading might be subject to the Commodity Exchange Act and, therefore, be in violation of the Office Exchange Trading Prohibition. And the result of that was to send over to London a very significant amount of commodity swap trading at that time, some of which has not come back to this country.
Also in that period, in fact, there was a court decision involving trading in the international Brent oil market, which is one of the principal international markets for oil. And that decision basically sent such shivers down the spines of the participants in that market that the foreign participants in that energy market refused to do business with the energy sector in the United States, and a lot of firms relocated trading operations to London in order to continue to participate in that market.
And that market, the center of gravity of that market, was probably almost as much in the United States as it was in Europe before that decision; but is now predominantly outside the United States because frequently when these things happen, they don't come back.
Mr. RAISLER. Just to elaborate on that point, Congressman Lucas, that really is what originally had the Energy Group come together in an earlier form and to lobby this committee and the Congress for relief in 1992 and then the Commission for relief to try to bring some of that business back.
It was only in part successful because, I think as Mr. Rosen indicated, once a market leaves the United States, it has an inertia that makes it very difficult to bring that market back. I think the activity of this committee and the CFTC in the early 1990's helped but did not resolve or solve to the satisfaction of the U.S. companies that formed the Energy Group, to bring the center of gravity of business from the United Kingdom back to the United States. So these are very serious and real problems.
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Mr. LUCAS. I would just offer an observation to the panel of my constituents who come to my town meetings, the handful who know about or care about or are aware of you tend to be almost as suspicious of your industry as they are of the United States Congress.
So there is a shared view out there that we have a responsibility to move very carefully and very methodically, Mr. Chairman, in whatever we do because of the potential impacts that this industry has on the lives of everyone out there be they wheat farmers or folks in some segment of the energy industry or anywhere up and down the economic chain.
They don't understand you particularly well. They know that you impact them, and they are very curious about your actions and ours.
Thank you, Mr. Chairman.
Mr. EWING. Thank you. Mr. Goode.
Mr. GOODE. I would like to ask Ms. Carlin what would you estimate is the total volume on the OTC derivatives market last year, total volume dollarwise?
Ms. CARLIN. I honestly need to defer that question to someone else.
I don't know. Joe, any guess?
Mr. BAUMAN. I believe the OTC market outstanding contract volumes is put on the order of $30 trillion or thereabouts with a very heavy qualifier that as whenever the volume numbers are mentioned, that that is not a measure of risk.
That is simply a measure of outstanding contracts. It would be as if to say that the foreign exchange market transacts trillions of dollars a day and to multiply that by the number of days in the year it does not reflect the risks of those transactions.
It is just a measure of activity and indeed has grown very steadily over the last 15 years to those levels.
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Mr. GOODE. Now, when you say $30 trillion, that is your estimate for today?
Mr. BAUMAN. Correct. Based on surveys that are taken of individual firms that participate in the market.
Mr. GOODE. Of that, what percentage would be in the United States at least having one participant in a transaction being in the United States? Half of it? More than half?
Mr. BAUMAN. This would be a guess, but I would guess that between 35 and 50 percent are accounted for by U.S. firms. Maybe more.
Mr. GOODE. I know in Ms. Born's testimony she stated that international settlements estimated that it is $70 trillion in notional value worldwide.
Mr. BAUMAN. I think that would have included exchange traded derivatives as well as OTC.
Ms. CARLIN. I do think, though, you can see the impact of regulation, frankly, when you unbundle these numbers, including the U.S. component from product to product.
So, as an example, and I will just tell you our little story, at Morgan Stanley Dean Witter, I would say at least 80 percent of our interest rate swap activity occurs in the United States. Interest rate swaps enjoy great protection currently under the Commodity Exchange Act through an exemption.
Our equity swap activity I cannot say that 80 percent is conducted in the United States. In fact, I don't want to guess on the record, frankly, but I bet you the difference is very different.
Mr. GOODE. Just so I can get some kind of idea here what $50 trillion is or $35 trillion or $70 trillion, what was the total volume on the New York Stock Exchange last year? Does anyone know that? Anyone got a ballpark? Mr. Kimball?
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Mr. KIMBALL. I think the average is roughly 700 million shares a day. 250 business days. If any of our minds can handle that.
Mr. GOODE. I kind of guessed that $75 trillion is somewhere in the ballpark?
Mr. ROSEN. Congressman, we would be glad to get you that information.
Mr. KIMBALL. Actually, the dollar volume, actually I have that for—this may be somewhat helpful. For the whole world, the daily volume in equities is $80 billion a day for the entire world, all the equity markets in the world, and the United States is probably oh, probably 30 to 40 percent of the market turnover.
Mr. GOODE. It is not going to be $75 trillion then.
Mr. KIMBAL. Fixed income all of the bond markets in the world $700 billion a day in turnover, and then the foreign exchange market is the granddaddy of them all with a trillion and a half a day.
Mr. BAUMAN. Congressman, keep in mind while you are speaking of the numbers, when you ask the question about OTC derivative volumes, those are outstandings as compared to turnover numbers, probably about a third of that number turns over every year.
Mr. GOODE. Mr. Rosen, as a representative of some of the banks, say your top 10 banks based on deposits in the United States, what percentage of the activity is in OTC derivatives.
Mr. ROSEN. I couldn't begin to guess the answer to that question. I would be glad to get it for you.
Mr. BAUMAN. I think I can say that for our institution. I
probably might want to revise the number for the record, but
the relevant number would be how much our exposure is to the
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OTC markets relative to our deposit base or capital. And I
believe that number is on the order of $10 billion compared to
deposits at the bank of probably about $350 billion.
Mr. GOODE. Mr. Cochrane in the panel before you indicated that with OTC derivatives as I understood him to say, that was about 5 percent margin but on stocks he said about 50 percent.
Is that what he said?
Ms. CARLIN. I think he was referring to the futures margin requirement when he used the 5 percent figure. Frankly I am not sure we really ever got to the bottom of the comparison between futures and options, but I think he was comparing futures and cash stock when he said that.
Mr. GOODE. Thank you.
Mr. EWING. Mr. Etheridge.
Mr. ETHERIDGE. Thank you, Mr. Chairman. Let me ask Ms. Carlin and Mr. Rosen and some others may want to comment on this but for you two specifically. What is the most important reform we can make for the OTC community?
Ms. CARLIN. Well, you may have heard in my oral testimony that the Securities Industry Association which has as its primary focus securities and securities derivatives believes that hybrid and derivative transactions involving non-exempt securities must be excluded from the act, and we need to promote the current exemption for exempt securities to an exclusion.
So that would be our most important point.
Mr. ROSEN. I would agree largely with Jane's observations.
We believe the most important thing is to codify an exclusion for privately negotiated transactions and hybrid instruments with very objective criteria that create as much legal certainty as possible and make it clear that that applies whether or not you are involved in non-exempt securities or any other form of product.
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Mr. ETHERIDGE. Thank you.
You talk about these legal certainties. Let me ask you a question on that. Can you provide some concrete examples of how the CEA's legal uncertainty has moved the OTC activity? I know you talked about some of that earlier. Maybe you can be a little more specific.
Mr. ROSEN. For example, most of the development—not a 100 percent of it but electronic trading systems, for example, there are electronic trading systems being developed in London.
I have a client and they have an electronic trading system for trading interest rate products. They are regulated in the United Kingdom and U.S. banks cannot participate in that market from the United States because of the CFTC.
CFTC sent them a letter saying what are you doing, tell us about your product, we want to look into this, and it had a chilling effect. So that activity is being conducted in London and other banks outside the United States can participate in—banks in the United States cannot participate in that market. People that are developing clearing mechanisms for OTC derivatives are concentrating that activity in London because of the regulatory obstacles that are created under the Commodities Exchange Act.
Mr. BAUMAN. It might be worth also, if my recollection is correct, Congressman, that at the hearings that were held last year concerning the standstill legislation, that testimony was given that the mere threat of the existing contracts being—some of them being deemed to be futures contracts put people on the record—I can't recall who was giving the testimony at the time, but I am sure the record shows that the threat of that led firms to consider very seriously moving activities oversees. And it was just the actions of the committee in providing the standstill capability that kind of took that off the agenda for a period of time.
Were that to be raised again, I am sure the same concerns would be raised.
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Ms. CARLIN. I agree with virtually everything Ed and Joe have said. Just a further anecdote maybe from the near-death experience of the concept release last year. It not only, of course, represented what we considered to be a change in policy that would be applied prospectively, but, frankly, I began worrying a lot about the impact on existing transactions.
When you have a statute that effectively allows legal uncertainty to continue so that the regulator can effectively come out with a statement which on many levels redefined existing standards as we understood them in the act, you can imagine the impact on existing transactions.
That is why certainty is so important. We shouldn't still be spinning and arguing and debating what these things mean. Either it is OK or it isn't OK.
Mr. ETHERIDGE. You have somewhat answered the question I was going to ask next, the issue versus legal certainty versus administrative things that people can do administratively, and I think you just answered that question.
Mr. SALTZMAN. Sir, I think the important point not forget is the reason why legal certainty is so critical is an illegal off-exchange future gives the counterparty a put so this isn't a situation where you can—there are recision rights though, I think as Ms. Carlin and others have been saying, this is not just an issue of an administrative penalty.
It is actually changing the very nature of the contract and shifting the risks.
Mr. ETHERIDGE. Let me ask this final question. I think you both have said and maybe all of you touched on it, Congress should allow clearing of the OCT derivatives.
Help me out. What do you mean by ''clearing''? Is it the same as clearing on the Chicago's organized exchanges? Is that what you are talking about?
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Mr. ROSEN. I think the answer to your question is that is a wide spectrum of mechanisms that you can use to clear, including what the futures exchanges do.
I think the last thing we want to do as a matter of policy is to discourage or create disincentives for creating clearing mechanisms however they are constituted. We recognize that a clearing can create concentrations of risk and may raise issues. And we think those issues should be addressed on their merits, but absolutely we think that our use of a broad range of clearing mechanisms ought to be available and the action not stand as an obstacle to that.
Ms. CARLIN. The only thing I can add to that is clearing can take effectively the form we have seen at the organized clearing corp. It can take different kinds of forms, more or less and all that.
The thought I would leave you with on clearing is if you look at the work of the counterparty risk management policy group that has been focused on all of these risk management and credit risk management issues, I think you will see some very valuable learning on this point including the fact that clearing is good.
Netting is good. These things reduce systemic risk, and they should not be used as excuses to assert jurisdiction when the underlying instrument is not itself subject to jurisdiction.
Mr. ETHERIDGE. Thank you.
Mr. EWING. Thank you, panel, for a very interesting session and for your answers and you may well receive some additional questions in the mail which we would appreciate your responding to in writing and they will become part of the record.
And with that, the subcommittee is adjourned.
[Whereupon, at 1:00 p.m., the subcommittee was adjourned, subject to the call of the Chair]
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[Material submitted for inclusion in the record follows:]
Testimony of Paul G. Kimball
Chairman Ewing and members of the subcommittee, I am delighted to be here this morning to talk about the importance of the foreign exchange market in the context of your deliberations over the future of the Commodity Exchange Act and the Commodity Futures Trading Commission. I request that my entire written statement be included in the record, in case I have to abbreviate my remarks because of time constraints.
My name is Paul Kimball. I have been trading foreign exchange for almost 25 years, and I am currently a managing director of Morgan Stanley Dean Witter. The Foreign Exchange Committee, which I chair, was formed in 1978 under the sponsorship of the Federal Reserve Bank of New York and includes representatives of major international banks and brokers active in foreign exchange markets. We have decades of experience—not only in foreign exchange, but also in exchange-traded futures and other over-the-counter markets. In that vein I should note that I am on the board of directors of the Chicago Mercantile Exchange—and moreover, not the only member of the Foreign Exchange Committee to serve in such a capacity.
THE IMPORTANCE OF THE FOREIGN EXCHANGE MARKET FOR THE U.S. ECONOMY
Companies trade foreign exchange for a number of reasons. One simple example would be when industrial concerns, agricultural firms, and other corporations need to buy or sell foreign currency in order to buy or sell products abroad. For example, if a manufacturer of agricultural machinery or an exporter of wheat sells its goods in a foreign country, it will need to convert that foreign money into U.S. Dollars in order to bring those profits back to the United States. The same company may need to pay employees or open an office abroad, which means that it may need to convert U.S. Dollars into the currency of that foreign country where it is doing business.
A foreign exchange trade itself has three necessary stages that cannot be separated from one another. First, there is trade execution, which is the process by which companies bargain over prices for foreign exchange deals and actually strike a deal. Next there are both trade clearing and trade settlement, which are how companies arrange to pay what they owe each other as a result of their deals. Without one, you can't have the others.
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Trading is global in scope. This is an astoundingly huge market: the equivalent of almost $1.5 trillion of foreign exchange is traded around the world every day. We have all admired the growth of the stock market over the past few years, but it is worth noting that in the United States alone, the size of foreign exchange turnover is seven times the size of the stock and bond markets combined.
I could continue to throw out large numbers, but the real story of foreign exchange is the way in which it helps U.S. companies, their employees, and consumers find a place in the worldwide marketplace. Being able to buy, sell, trade, and invest in foreign exchange helps businesses—not just in New York, Chicago, and Los Angeles, but also in Peoria, Omaha, and Modesto—import, export, expand, employ workers, and compete. A freely functioning over-the-counter marketplace in foreign exchange has been essential to the U.S. economy and should be allowed to play an even greater role in the future.
COMPETITION AND INNOVATION IN THE FOREIGN EXCHANGE MARKET
If you think that a huge global market like foreign exchange is extremely competitive, then you are absolutely right. Competition is fierce, not only among the many financial institutions that deal in foreign exchange, but also among the centers for over-the-counter foreign exchange dealing that have prospered around the world. The United States is by no means the only game in town. Only 25 percent of the world's foreign exchange activity occurs in this country: London has a bigger share of the market than we do, and their lead actually keeps on increasing. There are a host of other cities—Tokyo, Singapore, Hong Kong, and Frankfurt among them—that would love to increase their share of business at our expense.
As a result of the competition among foreign exchange firms and dealing centers, there has been a great deal of technological innovation in the way the foreign exchange business is conducted. I am talking about the trade execution, clearing, and settlement stages of a foreign exchange trade, which I mentioned before. Foreign exchange business that used to be transacted over the phone and on paper is now done by computer: it has revolutionized our business as much as PCs have changed the way Americans do office work. As a result, trade execution, clearing, and settlement have become more seamless, more efficient, and less risky.
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The use of automation in the foreign exchange market has also been the result of regulatory pressures by banking and securities regulators around the world, who are quite knowledgeable about the functioning of our business. As an example, the Basle Supervisors Committee, which is composed of supervisors from leading industrialized countries—including the Federal Reserve, the Comptroller of the Currency, and the FDIC from the United States—has called upon our industry to make specific technological advances that reduce risks. Some of these techniques enable firms to reduce certain risks as much as 90 percent. In order to ensure the vigor and safety of the U.S. foreign exchange market in the future, the current regulatory environment that has fostered these initiatives must not be changed.
Competition and electronic execution, clearing, and settlement in foreign exchange have meant two things. First, they have made firms like mine deliver our services faster, better, cheaper, and safer for the businesses that use foreign exchange. That is obviously good news for U.S. companies who are dependent on this market. Second, competition makes foreign exchange dealers very wary of doing business in countries where any aspect of foreign exchange trading—especially the use of automation—has unnecessary regulatory burdens.
The over-the-counter foreign exchange market in the U.S. needs no additional regulation. Accordingly, this business will move overseas and become greatly diminished in the United States if greater regulatory burdens result from this subcommittee's deliberations. I'll admit that has strategic and financial implications for me and my firm. But more important, it means that foreign exchange trading would become more difficult and expensive for U.S. firms who need it to grow and compete. That would be bad for U.S. companies, bad for their employees and their communities, and bad for the U.S. economy.
SUPERVISION AND SELF-POLICING IN THE FOREIGN EXCHANGE MARKETS
The foreign exchange market is already subject to a great deal of effective external and internal regulation, which is another reason for the subcommittee to avoid imposing new regulatory burdens on this business.
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First, the vast preponderance of institutions who serve as dealers in the foreign exchange market are very sophisticated financial institutions regulated by any number of state and Federal regulators in the United States. The Securities and Exchange Commission, the Federal Reserve, the Comptroller of the Currency—these are among the financial industry regulators that scrutinize trading activities like foreign exchange, depending on the legal entities firms like mine choose to use for this type of activity. Add to that mix the potent laws against fraud that exist at the Federal and state levels, which guard against dishonesty and unfair dealing in the professional market.
Finally, consider the many successful efforts at self-policing that institutions active in foreign exchange have initiated over the past 20 years. Those of us who make our livelihood in foreign exchange take our industry's reputation very seriously; we know that even one bad apple can spoil our record. The Foreign Exchange Committee and other similar groups have for years published best practice guides, alerts, and letters that have helped raise standards to a very high level.
The foreign exchange business in the United States has done a better job than even some very heavily Government-regulated markets in maintaining the level of integrity with which we do our jobs. No wonder there has been an absence of serious scandals, lawsuits, and disruptions in the professional foreign exchange market. I believe the combination of effective supervisory oversight of most institutions in the foreign exchange market, combined with the standards that the industry has itself embraced, should be a model—rather than a target—for the subcommittee to consider as it turns to the future of Commodity Exchange Act.
VIEWS OF THE FOREIGN EXCHANGE COMMITTEE
Mr. Chairman, we have Congress to thank for the competitive, efficient, and effective over-the-counter foreign exchange market in the United States today. The reason is the enactment of the so-called Treasury amendment in 1974, which sought to ensure that the Commodity Exchange Act would never interfere with or otherwise affect foreign exchange trading, except when it occurred on futures exchanges like the ones this subcommittee oversees. The Treasury amendment represented an insightful decision by Congress to allow the foreign exchange market to flourish and grow—and along with it, the U.S. businesses and consumers that benefit from this market. It was designed precisely to foster advances like those in electronic trading that I've mentioned today.
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Our very important foreign exchange market depends on the Treasury amendment, and because of that, we urge Congress to preserve the intent of the Treasury amendment going forward. Congress should clarify the Treasury amendment so that it fully excludes over-the-counter foreign exchange trading from the Commodity Exchange Act—including any elements of trade execution, clearing, and settlement that have or will become automated. In doing so, you can ensure that the innovation, efficiency, safeguards, and economic growth brought to this country by the professional foreign exchange market will continue.
You will notice that I just referred to what I called the professional foreign exchange market. By that, I mean foreign exchange trading that is done between entities that are big enough not to need special regulatory protection. The Foreign Exchange Committee feels strongly that the law should provide appropriate protections for victims of unregulated bucket shops who take advantage of small customers at the retail level.
I understand that Congress may feel pressure to impose new regulatory burdens on the over-the-counter foreign exchange market as a result of the regulatory burdens currently faced by futures exchanges. As an employee of a firm having operations regulated by the CFTC, I know the burdens of the Commodity Exchange Act. But I hope you would agree that regulation for regulation's sake is never a good idea. Moreover, as I learned long before I became a foreign exchange trader or a member of the board of the Chicago Merc, two wrongs don't make a right.
Mr. Chairman and members of the subcommittee, I deeply appreciate the opportunity to tell you more about what we have accomplished in the over-the-counter foreign exchange market and its importance to our economy. The Foreign Exchange Committee is honored to be included in a discussion of issues that have such tremendous significance to our economic future. I look forward to your questions.
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Testimony of William J. Brodsky
I am William J. Brodsky, chairman and chief executive officer of the Chicago Board Options Exchange. I appear today on behalf of CBOE and nine other securities markets that comprise the U.S. Securities Markets Coalition: the American Stock Exchange, the Boston Stock Exchange, the Chicago Stock Exchange, the Cincinnati Stock Exchange, the Nasdaq Stock Market, the National Securities Clearing Corporation, the Pacific Exchange, the Philadelphia Stock Exchange and The Options Clearing Corporation.While the New York Stock Exchange is not officially a member of the Coalition, it supports the views presented in this testimony. The U.S. securities markets represented by the Coalition are vital to the health of the U.S. economy and serve as the investment vehicle or retirement savings choice for over 70 million Americans. The Coalition welcomes this opportunity to provide its views on issues pertaining to the CFTC reauthorization.
The Agriculture Committees of the Senate and House of Representatives are engaged in an exploration of various issues involving futures, over-the-counter derivatives, and the Commodity Futures Trading Commission in connection with the CFTC's reauthorization. The U.S. securities markets have an important interest in three issues arising from CFTC reauthorization—the treatment of futures on individual stocks and narrow-based stock indexes and the status of equity swaps—that are integrally related to the securities markets.
Our essential message is that the Shad-Johnson Accord, codified as Section 2(a)(1)(B) of the Commodity Exchange Act, is well-considered legislation. The underpinnings of the Accord are as valid—if not more so—today as when the CEA was originally enacted. Consequently, we oppose attempts to repeal or weaken the accord's prohibition on futures on individual stocks and narrow-based stock indexes and limit the Securities and Exchange Commission's ability to review proposed stock index futures contracts.
We fully agree with SEC Chairman Levitt, who has stated that any amendments that fundamentally affect the Shad-Johnson Accord ''should be enacted only after the type of consultation and cooperation displayed by the Commission, the CFTC, and their oversight committees in reaching the Accord in 1982.''Letter dated February 12, 1997 from Arthur Levitt, Chairman, SEC, to Senator Richard Lugar, Chairman, Senate Committee on Agriculture. Therefore, we believe that Congress should reject attempts by the futures exchanges to eviscerate the Shad-Johnson Accord through the CFTC reauthorization process.
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In regard to equity swaps, we agree that providing legal certainty that equity swaps are not subject to the CEA would be helpful to the markets. We believe the correct means to provide such certainty is to exclude equity swaps from the CEA and make clear that the SEC has the authority to exercise appropriate regulatory oversight over these products.
EQUITIES ARE DIFFERENT
The U.S. equity securities markets are unique among equity markets around the world and are a pillar of strength in our economy. Over 70 million Americans are invested in the stock market, either directly or through mutual funds, and tens of millions more invest through their pension plans. The U.S. investor community is immense and spans not only the Nation geographically, but also spans a very broad segment of the economic spectrum.
According to a survey by the Nasdaq Stock Market, 43 percent of American adults either own stock in individual companies or mutual funds.A National Survey Among Stock Investors, Conducted for the Nasdaq Stock Market by Peter D. Hart Research Associates (1997). Money continues to be invested in equity securities at a brisk rate. This includes money from pension funds, IRA's, 401-K's and similar sources representing much of the accumulated wealth of our nation, and the savings and financial security of our workers. Indeed, the financial well-being of the nation, both short-term and long-term, is more and more dictated by the stock market. The stock market is a unique American strength, and the stability and integrity of this national asset are paramount concerns.
Underpinning the stability and integrity of the U.S. stock markets is a sound regulatory system. Consequently, proposals that affect the entire fabric of the regulatory system for stocks and related derivatives must not be undertaken lightly. Proposals to repeal important stock market protections provided by the Shad-Johnson Accord should only be considered after full review by the SEC, its relevant oversight committees in Congress, and affected securities markets. For the reasons discussed below, we believe that repeal or weakening of Shad-Johnson prohibitions on futures on individual stocks and narrow based indexes would prove dangerous to the securities markets. Consequently, we strenuously oppose proposals to remove or weaken these prohibitions.
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SHAD JOHNSON ACCORD ISSUES
The prohibition against futures on individual stocks and narrow-based stock indexes was the result of a jurisdictional accord between the SEC and CFTC in 1982, commonly referred to as the Shad-Johnson Accord. The Accord treats options on securities and options on a group or index of securities as securities while regulating futures on a broad-based index of stocks as futures contracts under the CEA. During negotiation of the Accord, the SEC expressed serious concerns about the possibility of futures on individual stocks. The Federal securities laws were designed for different purposes than the Federal commodities laws. As a consequence, the SEC and securities markets were concerned that if futures on stocks were regulated as futures and not as securities, the lack of securities market investor protections could cause stock futures to disrupt the market for the underlying stocks and impair market integrity. Unlike securities, including stock options, futures are not subject to insider trading prohibitions and suitability requirements for recommendations to customers. Futures also have substantial leverage due to very low margin requirements. It was the SEC's view that the extreme futures leverage, combined with the lack of key securities markets protections, would cause futures on individual stocks to be a tool for stock market manipulation.
Despite these concerns, the CFTC insisted that futures on individual stocks be regulated under the CEA while the SEC believed they should be regulated as securities. As a consequence of this disagreement, the two agencies determined to ban futures on individual stocks. They also agreed to prohibit futures on narrow-based indexes of stocks, which could easily be used as a surrogate for a future on an individual stock. Thus, futures on securities were limited to broad market indexes, where the breadth of the index would minimize the possibility of insider trading and manipulation concerns. Indeed, in the SEC/CFTC Joint Explanatory Statement submitted to Congress to enact the Accord, the SEC and CFTC stated that the requirement that a futures contract be based on a broad market index ''is intended to provide adequate flexibility for the market to respond to the needs of participants, while assuring that only broad-based securities index futures contracts that are not conducive to manipulation could be authorized.''[1981-82 Transfer Binder] Fed. Sec. L.Rep. (CCH) -83,096 at 84,843 (Feb. 2, 1982).
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The Chicago Mercantile Exchange and the Chicago Board of Trade recently have proposed that the Shad-Johnson Accord's prohibition on futures on individual stocks and narrow-based stock indexes be repealed and the SEC's authority to approve stock index futures contracts be removed. We are vehemently and unalterably opposed to revisions to the Accord that would permit futures on individual stocks or narrow based indexes. The policy concerns that led Congress to prohibit futures on individual stocks and narrow-based indexes and to impose special requirements on futures on broad-based indexes pursuant to the Shad-Johnson Accord in 1982 have not changed, and apply with equal force today. Indeed, these concerns are even more relevant today due to increased public participation in the stock market since enactment of the Accord.Just ten years ago, only 36 million Americans were invested in the stock market. Today over 70 million Americans are invested in the stock market (and tens of millions more through pension plans) In our view, repeal or weakening of Shad-Johnson Accord provisions would entail grave risk to the underlying securities markets without providing appreciable benefits to investors.
For example, there continue to be no prohibitions against insider trading in the CEA, so a person could trade on inside information with impunity using futures on individual stocks. Similarly, there are no suitability provisions for recommendations to customers in the futures laws as there are in the securities laws. Futures rules only require that a salesperson collect financial and other information on a new customer when approving the customer to open a futures account. There is no requirement that a salesperson recommending a futures transaction to a customer determine that the recommendation is suitable for the customer. In contrast, the securities rules require a broker to make a suitability determination for every recommendation to a customer. Because of the lack of securities-like suitability provisions for futures, if futures on individual stocks and narrow-based indexes were permitted, they could be freely marketed to unsophisticated and unsuitable investors.
Finally, futures transactions require much smaller margin than do securities transactions. ''Margin'' refers to credit extended to establish a position in the securities markets and the performance bond required to enter into a futures contract. For both securities and futures, the amount of margin controls the amount of leverage in the instrument. Stock index futures margins usually represent 5 percent or less of the contract value, whereas the Federal Reserve Board establishes a 50 percent margin requirement for stock transactions. For securities options, purchasers must pay the full purchase price while sellers must put up margin equal to the premium plus 15 percent of the underlying security's value for options on broad-based indexes and the premium plus 20 percent of the underlying security's value for options on stocks or narrow-based indexes. Thus, to purchase $10,000 worth of stock, an investor would need to make an initial payment of at least $5,000. A stock option writer would have to pay the options premium plus $2,000. To establish a comparable futures position, however, the initial payment would need to be only $500 (assuming 5 percent margin, which is the typical stock index futures margin). Should futures on individual stocks or narrow-based indexes be allowed, such dramatic disparities in margin requirements for stock futures and securities transactions could have profound ramifications for the U.S. equity market in three areas: customer losses, systemic risk, and manipulation.
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Leverage and Customer Loss:--Leverage relates to an investor's exposure to loss from price movements. The greater the leverage, the greater the risk of substantial loss. For instance, leverage based on a margin of 5 percent—the typical stock index future margin—magnifies loss associated with a small price movement twentyfold. In times of market volatility, highly leveraged investors are exposed to huge losses and are required to produce large amounts of cash to cover daily or even intra-day margin calls.
Leverage and Systemic Risk:--In times of extreme market volatility, substantial leverage in a financial market can place severe strains on liquidity and endanger the financial integrity of the system as a whole. Investors struggling to make futures margin calls may well liquidate securities positions to raise needed funds. Widespread customer defaults stemming from the overuse of leverage could significantly impair market integrity.Indeed, in a recent report on hedge funds, the President*s Working Group on Financial Markets noted that *The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution can be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets.* Letter dated April 28, 1999, from Robert E. Rubin, Secretary, Department of the Treasury, Alan Greenspan, Chairman, Board of Governors of the Federal Reserve, Arthur Levitt, Chairman, SEC, and Brooksley Born, Chairman, CFTC, to the Honorable J. Dennis Hastert, Speaker, U.S. House of Representatives, Transmitting Report of the President*s Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, April, 1999.
Leverage and Manipulation:--The high degree of leverage for futures, when concentrated into a future on a single stock, also would significantly raise the risk of manipulation. The potential to obtain a large profit from a futures position due to a move in a single stock's price could induce attempts to manipulate stock prices. The heightened risk of manipulation could lead highly leveraged stock futures to destabilize the stock market and impair the integrity of the equity pricing mechanism.
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In an attempt to alleviate concerns about the regulatory disparities between securities and futures, the Chicago Mercantile Exchange and Chicago Board of Trade have proposed to empower the SEC to apply insider trading prohibitions to futures on individual stocks. We have serious reservations about how and whether this authority would work. More fundamentally, it would not address the other regulatory disparities between securities and futures and would perpetuate the split regulation of stocks and stock surrogates such as futures on individual stocks and narrow-based indexes. Consequently, the proposal is inadequate to address the concerns that underlie the prohibition on futures on individual stocks and narrow-based indexes.We also oppose any attempt to remove the SEC*s authority to review proposed stock index futures contracts. The SEC has no ability to oversee trading on futures markets or regulate trading practices in stock index futures contracts. Hence, it is critical for the SEC to continue to review proposed stock index futures contracts for possible susceptibility to manipulation and stock surrogates concerns before they are permitted to trade.
With over 70 million Americans invested in the stock market, either directly or through mutual funds, and tens of millions more investing through their pension plans, it is critical to maintain the pricing integrity and sound operation of the securities markets. Permitting futures on individual securities or narrow-based indexes could undermine enforcement of the securities laws and lead to market disruptions and customer abuses to the detriment of market integrity and investor confidence. This would present a risk to the assets of American citizens that we simply can not afford to take.
Our concern on this matter extends equally to futures on narrow-based indexes as it does to futures on individual stocks. In light of the regulatory disparities between futures and securities, Congress, in enacting the Shad-Johnson Accord into legislation in 1982, wanted to ensure that futures would only be traded on stock indexes that were broad enough to be an inadequate surrogate for trading an individual stock or small group of related stocks. In light of the regulatory disparities that continue between securities and futures, it is important to maintain the prohibition against futures on indexes that can act as a surrogate for a single stock or a small group of related stocks.
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While we believe that the narrow based index provision serves an important function, we note that the SEC has attempted to administer this provision in a pro-competitive manner. It has not objected to futures on sector indexes that it believes can not act as a surrogate for a single stock or small group of stocks. Moreover, to provide flexibility and certainty for the futures exchanges, the SEC and CFTC issued a Joint Policy Statement in 1984 on the criteria that sector index futures could meet to satisfy the Accord.Joint Interpretation and Statement of General Policy, 49 F.R. 2885 (Jan. 24, 1984). Since the issuance of the Joint Policy Statement, the SEC has worked with the futures exchanges and the CFTC to approve nearly 70 stock index futures proposals. For example, the SEC recently found that a stock index future based on the internet sector and a stock index future based on the real-estate sector could meet the Shad-Johnson Accord criteria.See Letter dated November 18, 1998 from Richard R. Lindsey, Director, Division of Market Regulation, SEC, to Steven Manaster, Director, Division of Economic Analysis, CFTC, regarding the Standard and Poor*s REIT Composite Index Futures Contract; and Letter dated March 12, 1999, from Robert L.D. Colby, Deputy Director, Division of Market Regulation, SEC, to Steven Manaster, Director, Division of Economic Analysis, CFTC, regarding the Internet Stock Price Index Futures Contract. In the past, the SEC also has found that other futures on sector indexes, such as a utilities index future, could meet the Accord criteria.See Letter from Douglas Scarff, Director, Market Regulation, SEC, to James A. Culver, Director, Division of Economics and Education, CFTC, dated September 15, 1982. The SEC has objected to only two of the over 70 proposals for new stock index futures contracts since issuance of the Joint Policy Statement for failure to meet the Accord standards, and for those contracts the SEC found that the proposed indexes were comprised of too few stocks.See Securities Exchange Act Release No. 40216 (July 16, 1998).
The Shad-Johnson Accord represents a careful balancing of the securities and futures regulatory structures. It is imperative that the concerns about the regulatory treatment of futures on individual stocks and narrow-based indexes be appropriately and completely addressed before any reconsideration of the Shad-Johnson Accord is undertaken. Otherwise, the lack of important market and investor safeguards designed to deter manipulation, insider trading, excessive leverage, and unsuitable sales practices would lead futures on individual stocks and narrow-based indexes to disrupt the securities markets and undermine investor confidence. These differences make it essential for the SEC to play a role in this process. Most fundamentally, in light of our concerns about the regulatory disparities between futures and securities, the Coalition strongly opposes a lifting of the ban on futures on individual stocks and narrow-based indexes.As noted above, the regulatory schemes for securities and futures developed differently in order to address the different public policy issues posed by securities and futures. For example, a significant number of retail investors participate in the securities markets while the futures markets have been predominantly institutional and commercial. We note, however, that it is likely that futures on individual stocks and narrow-based indexes would be marketed to retail investors, thus heightening our concern over the impact of the regulatory disparities if any lifting of the Shad-Johnson prohibitions occurred.
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Equity Swaps. Another issue that has received attention during the CFTC reauthorization process has been the legal status of OTC derivatives. The attention devoted to this issue arises, in part, from issuance of a Concept Release on OTC Derivatives by the CFTC last year.63 F.R. 26114 (May 12, 1998). The Concept Release raised questions as to the status of certain OTC derivatives in regard to the CEA. While the Coalition has refrained generally from becoming engaged in the debate stemming from the OTC Derivatives Concept Release, we do have a particular interest in matters pertaining to legal certainty for equity swaps because of the products nexus to the equity markets.
The Coalition believes that equity swaps should not be subject to the CEA. Clarifying the legal status of equity swaps would benefit dealers, end-users, and the markets generally. If Congress determines to provide clarification of the legal status of equity swaps, however, it should do so by excluding equity swaps from the CEA and making clear that the SEC has the authority to exercise appropriate regulatory oversight over these products.
The Coalition agrees with the Department of Treasury, Federal Reserve Board and SEC that equity swaps are not, and should not, be subject to the CEA. In general, the CEA is designed to regulate exchange-traded futures and is not equipped to cover privately negotiated bilateral instruments such as equity swaps.
The CFTC has the authority to exempt all swaps but equity swaps from the CEA. Some market participants have suggested that the CFTC be granted the same authority with respect to equity swaps. The Coalition agrees that clarifying that equity swaps do not fall under the CEA would reduce unnecessary legal risk for U.S. financial markets. At the same time, an exemptive approach to equity swaps could raise implications about the SEC's ability to react to issues arising from this product. The SEC, as regulator of the securities markets, has a vital interest in instruments involving the securities markets. Hence, if Congress determines to provide greater legal certainty for equity swaps vis-a-vis the CEA, it should do so by excluding equity swaps from the CEA and making clear that the SEC has the authority to exercise appropriate regulatory oversight over these products. This is the approach advocated by the SEC in its Written Statement Regarding S–257 before the Senate Agriculture Committee dated March-14, 1997.
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Thank you for giving us the opportunity to express our views. The Coalition looks forward to the opportunity to work with Congress as it grapples with the difficult issues posed by reauthorization of the CFTC.
Testimony of James L. Cochrane
I am James L. Cochrane, senior vice-president, strategy and planning, and chief economist of the New York Stock Exchange. The NYSE welcomes this opportunity to provide our views on Commodity Futures Trading Commission reauthorization. Our interest in CFTC reauthorization is limited to analyzing and commenting on the likely impact of proposed changes in the CFTC's statute, the Commodity Exchange Act, on our market. As a result, we are acutely interested in proposals: (1) to change the Shad-Johnson Accord; (2) to clarify the legal status of equity swaps; and (3) to change the regulatory scheme applicable to existing and proposed stock index futures contracts.
THE NYSE'S INTEREST IN CFTC REAUTHORIZATION
The Unites States is home to the world's premier capital markets. Our equity market is the broadest, deepest, most efficient, most investor friendly in the world, providing both U.S. and non-U.S. issuers with a highly attractive environment in which to sell their securities. The U.S. stock market is unique in the world because of its enormous size and its high level of individual participation. At the end of April 1999, the market capitalization of domestic companies listed on the NYSE was $11.4 trillion. NYSE Historical Statistics, International & Research Division, May 1999.
This figure nearly exceeds 1997 total U.S. market capitalization. According to the 1995 Federal Reserve Board's Survey of Consumer Finances, almost 70 million individual Americans own corporate stock directly, through a mutual fund, through a supplemental retirement account or through a defined contribution pension account.
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NYSE Shareownership 1998, Summary, 4 (1998).
The number of individual investors continues to grow every day. As NYSE Chairman Richard A. Grasso has noted, ''This unique equity culture has become a model for nations around the world, as some move to strengthen their capital markets and others seek to switch from centrally managed to market-driven economies.''
Id., Letter from the Chairman, 3.
Individual Americans increasingly choose to save for their children's college education and for their own retirement by investing the stock market. For this reason, the NYSE is steadfast in supporting shareowners by providing a market that offers diverse global investment opportunities, the most advanced technology and the highest standards of integrity and regulatory oversight.
Id.
Without a doubt, determining if the CEA needs to be amended to assist the U.S. futures exchanges in meeting the competitive challenges that they face is a paramount issue in CFTC reauthorization. The NYSE is no stranger to competitive challenges. A large part of my job is to identify competitive challenges to the NYSE and to help to formulate responses to them. The NYSE faces competition on a variety of fronts: from international markets; other domestic markets; alternative trading systems; as well as broker/dealers which internalize investor order flow. Most of our competitors face lower levels of regulation than the NYSE. However, in examining options for responding to our competition, our threshold consideration is the impact in regulatory integrity.
Will investor protection be endangered? Will market integrity be compromised? Will the stock prices of listed companies be adversely affected for reasons unrelated to company-specific fundamentals? Will our technological capacity be overtaxed? If we can answer yes to any of these questions, we either reject the option or make modifications to it until we are confident that the proposed course of action does not threaten any of the NYSE's fundamental values. The NYSE also applies these rigorous standards in evaluating regulatory and statutory changes that would affect our market.
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IMPACT OF THE CME/CBOT PROPOSAL ON THE NYSE
Now I will turn more directly to the issue of CFTC reauthorization. My testimony will focus on the proposal put forward by the Chicago Mercantile Exchange and the Chicago Board of Trade because this proposal has been the starting point for discussion on the issues that Congress may address during this reauthorization. As relevant to the NYSE, the most important aspect of the CME/CBOT proposal is the repeal of Shad-Johnson.
REPEAL OF THE SHAD-JOHNSON ACCORD
Ironically, it is likely that if futures on individual stocks and narrow-based indices were allowed, the short-term impact on the NYSE would probably be an increase in our business. This is because professional dealers in single stock and narrow-based index futures in NYSE-listed stocks would likely hedge their positions by purchasing the cash product—the underlying stock—in our market. Indeed, hedging activity on the domestic options exchanges currently generates a significant percentage of NYSE volume.
Notwithstanding that the short-term impact of single stock futures could benefit our market, we believe that the long-term impact would be highly detrimental, not only to our market, but to our nation's capital raising system as a whole. This is because the futures regulatory regime, which is structured primarily to oversee an institutional market designed for commercial hedging, is fundamentally different from the securities regulatory regime. Legal and regulatory staples of securities regulation designed to protect public investors from excessive leverage, unsuitable investments, insider trading by corporate insiders and abusive short-selling simply do not exist in futures regulation. Because futures on single stocks and narrow-based indices serve no real economic purpose, any success that they might enjoy would be premised precisely on avoiding these regulatory requirements. Ultimately, we believe that permitting the sale of futures on single stocks or narrow-based indices without these crucial protections would undermine the integrity of the securities regulatory regime and investor confidence in that regime. As a result, the NYSE strongly opposes this aspect of the CME/CBOT proposal.
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Under the CME/CBOT proposal, futures on individual stocks and narrow-based indexes could trade in the U.S. for the first time. The futures regulatory scheme has worked relatively well with regard to broad-based stock index futures. However, these instruments are fundamentally different from futures on individual stocks and narrow-based indices. While price movements in broad-based stock index futures reflect general market trends, price movements in futures on individual stocks or narrow-based indices would predominantly reflect company specific or narrow industry events or trends. In addition, stock index futures are used primarily by large institutions, futures on individual stocks and narrow-based indices would be most likely be used by small retail investors.
Some stock index futures contracts have been tailored to retail investors, such as the CME*s E-Mini and the CBOT*s Dow Jones Industrial Average. This is a recent trend and indicates that futures on individual stocks and narrow-based indices likely would be marketed to retail investors.
This radical step is proposed without any indication that it is supported by any member of the President's Working Group on Financial Markets, let alone the SEC, the Federal financial regulator whose markets would be most affected by such a plan. The proposal also makes only one, ill-conceived concession to the significant regulatory differences between futures and securities. The CME/CBOT provides an inadequate basis on which to permit products that would permit differences between the CEA and the securities laws to be exploited to the detriment of investor confidence and market integrity.
INSIDER TRADING
The prohibition against insider trading is a crucial component of investor confidence in the fairness of the U.S. securities markets. The CEA contains no comparable prohibition. Thus, a company officer or director could legally trade on material inside information by buying or selling a futures contract on the company stock. When the material information became public, the price of both the company's stock and the future on the company's stock would be affected. The company officer or director could then pocket the profits on the futures contract without fear of prosecution under the securities or commodities laws. This blatant circumvention of the securities laws could be expected to adversely affect investor perceptions about the fairness of the U.S. securities markets.
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The CME/CBOT proposal does not overcome this objection to futures on individual stocks and narrow-based indices. The proposal would ''[e]mpower the SEC to apply insider trading rules to nonexempt securities-based derivatives traded on a futures exchange to the same extent as it applies those rules to options traded on a national securities exchange.'' The proposal provides no details on how the SEC, which has jurisdiction only over securities, would be so empowered and to what extent. Presumably, a change to the SEC's jurisdiction would be required. Also unanswered by the proposal are a number of important questions, including, but not limited to, the following. Would the SEC have the authority to examine the surveillance systems of any futures exchange trading futures on individual stocks or narrow-based indices to determine if these systems are adequate? Would such examinations include review of the exchange's audit trail to determine if trade times, which can be important in insider trading investigations, can be adequately determined? If the SEC does have the authority to examine the futures exchange's surveillance and other systems would these examinations occur under the standards of the CEA, as amended by the CME/CBOT proposal, or the standards applicable to securities exchanges under the 1934 Act?
These questions are crucial because many insider trading cases brought by the SEC or an U.S. Attorney's office are based on investigations begun by the NYSE and other SROs. Nearly one-third of the NYSE*s 1518 staff members are devoted to regulation.
NYSE investigations often begin on the basis of alerts generated by the NYSE's Stock Watch, our real-time surveillance system. Most alerts can be explained by company news, trends in the industry or national economic factors. Where no legitimate explanation is evident, the NYSE launches an investigation. The investigation begins by contacting the company to find out if there are any pending announcements. At the same time, surveillance personnel draw on an electronic audit trail to reconstruct the details of every trade that takes place. Rebuilding the time of trade execution enables NYSE investigators to see if any member firm or firms stand out in the trading.
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Next, the NYSE contacts the firm or firms involved and obtains the names of all customers involved in the trades under scrutiny. These names are automatically matched against the names of officers, directors, and other corporate and non-corporate insiders to detect any possible connection or illicit flow of information. This task is performed using the Automated Search and Match (ASAM) system which contains the names of 800,000 executives, lawyers, bankers and accountants, plus public profile data on officers and directors of approximately 80,000 public corporations and 30,000 corporate subsidiaries. Customer and trading information is also analyzed for geographical concentrations and compared with names and chronological events provided by NYSE-listed companies and member firms. If, after an investigation is completed, the NYSE uncovers suspicious trading practices by its members or their employees, it can take disciplinary action. For those outside the NYSE's jurisdiction, it can turn the information over to the SEC for further consideration.
Empowering the SEC to enforce insider trading prohibitions without assurance that the surveillance systems of the futures exchanges are as rigorous as those of the NYSE would be a hollow gesture.
MARGIN AND LEVERAGE
Margins on futures and securities are set in different ways and at significantly different levels. Margins on stock index futures are currently set at approximately 5 percent of contract value, so it could be expected that margins on futures on individual stocks or narrow-based indices would be set at comparable levels. Margins on stock index futures are set by the futures exchanges, with limited oversight by the CFTC.
Section 2(a)(1)(B)(v) of the CEA grants the Board of Governors of the Federal Reserve System (*the Fed*) limited oversight authority over margins on stock index futures. The Fed has delegated this authority to the CFTC.
The Fed sets initial margin on stocks at 50 percent.
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When comparing leverage in the futures and securities markets it is important to keep in mind that all futures transactions are leveraged, while only a relatively small number of stock transactions are made on margin.
If futures on individual stocks and narrow-based indices are permitted, these differences could have profound implication for the U.S. securities markets. Leverage relates to an investor's exposure to loss from price movements. The greater the leverage, the greater the risk of substantial loss. As the experience of Long-Term Capital Management last summer showed, a highly leveraged investment can magnify the loss associated with a small price movement significantly and, potentially, disastrously. Futures on individual stocks and narrow-based indices would be marketed to retail investors, and thus, expose these investors to potentially large losses in a very short time.
Further, in times of extreme market volatility, the existence of pervasive leverage can place severe strains on liquidity and endanger not only individual investors, but also the financial integrity of the system as a whole. Again, the LTCM experience is illustrative. The combination of extreme volatility in a number of markets and the highly leveraged book of LTCM led the Federal Reserve Bank of New York to the conclusion that responsible public policy required it to facilitate a working-out of LTCM's problems. The New York Fed took this step to stop those problems from effecting not just LTCM and its counterparties but the U.S financial markets and economy as a whole. See, Testimony of William J. McDonough, President, Federal Reserve Bank of New York before the Committee on Banking and Financial Services at 5 (Oct. 1, 1998).
Finally, the high degree of leverage for futures, when concentrated in a future on an individual stock or a narrow-based index would also significantly raise the risk of manipulation, especially around the time that the future expired. The potential to obtain a large profit from a futures position due to a price move in a single stock or a small number of stocks could induce attempts to manipulate stock prices. This heightened risk of manipulation could lead highly leveraged futures on individual stocks or narrow-based indices to destabilize the stock market and impair the integrity of the equity pricing mechanism.
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INVESTOR PROTECTION
Differences between the investor protection regimes under futures and securities laws could also have profound implications if futures on individual stocks and narrow-based indices were permitted. These differences are particularly important if, as is likely, futures on individual stocks and narrow-based indices are marketed to retail investors as cheap surrogates for stock. Securities SROs require continuing suitability determinations by brokers of their customers. Futures SROs do not impose ongoing suitability requirements with respect to stock index futures. Instead, the National Futures Association requires only that a risk disclosure statement be provided to customers when an account is initially approved for futures trading. Retail customers could suffer large losses without having the means to sustain such losses. If a large number of such losses occurred, it could undermine investor confidence in all financial markets, including the stock market. In addition, retail investors suffering such losses likely would want to know why Congress authorized the trading of these products without being certain that adequate customer protections were in place.
SHORT SALE RESTRICTIONS
The securities laws and the NYSE's own rules contain detailed restrictions on short sales. The NYSE's rule provides, among other tings, that short selling can occur only on a plus tick or a zero-plus tick. A plus tick is a price above the price of the last preceding transaction. A zero plus tick is a price equal to the last preceding transaction if the most recent transaction at a different price was at a lower price.
Restrictions on short selling were adopted to ensure the stability of the U.S. securities markets. These restrictions are extremely important to the listed companies of the NYSE. There are no comparable restrictions in short sales on the futures markets. Thus, trading in futures on individual stocks or narrow-based indices could easily be used to evade the short sale rules applicable to securities trading.
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SEC ROLE IN APPROVING STOCK INDEX FUTURES CONTRACTS
Finally, the CME/CBOT proposal would eliminate the requirement that the CFTC approve futures contracts before they are permitted to trade. Adoption of this portion of the proposal would vitiate the existing contract designation requirements and procedures for stock index futures contracts found at Section 2(a)(1)(B) of the CEA.
The proposal would preserve the requirement that all stock index futures contracts must be cash-settled. In the NYSE*s view, the minimum designation criteria in Section 2(a)(1)(B) of the CEA are intended to work as a whole. No single one of the three designation criteria alone would be effective in achieving the goal of protecting the underlying securities markets from manipulation.
Under these requirements, the SEC must determine whether an application to trade a proposed stock index futures contract meets the minimum designation requirements for these products articulated in Section 2(a)(1)(B)(ii)(I)-(III). The minimum requirements are ''intended to provide adequate flexibility for the market to respond to the needs of participants, while assuring that only broad-based securities index futures contracts that are not conducive to manipulation [can] be authorized.'' News Release from the United States Securities and Exchange Commission (SEC Release No. 82-9) and United States Commodity Futures Trading Commission (CFTC Release No. 883-82), SEC and CFTC Jurisdictional Agreement: Proposed Legislation, 7 (Feb. 2, 1982).
They recognize the legitimate interest of the SEC in products based on securities within the SEC's jurisdiction.
In the 17 years that Section 2(a)(1)(B) has been in effect, it has worked well. The tight statutory deadlines for SEC action insure that the SEC cannot indefinitely delay the designation of stock index futures contracts that meet the statutory criteria. At the same time, SEC review of proposed stock index futures contracts helps to insure that the statutory criteria, which help to protect the integrity of the underlying securities markets, are met. Only a very small number of proposed contracts have been disapproved by the SEC over the past 17 years. The NYSE continues to support the prior approval provisions of Section 2(a)(1)(B) and would oppose any change to these provisions that does not have the support of the SEC.
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LEGAL CERTAINTY FOR EQUITY-BASED DERIVATIVES
The CME/CBOT proposal would exclude all privately-negotiated derivatives, including equity derivatives, from the CEA. In this context, the NYSE is interested only in the legal status of equity-based derivatives. The NYSE is concerned about the legal status of equity swaps based on individual stocks or a narrow-based index of stocks because these products are so closely linked to our own market. We have consistently stated that equity swaps should be subject to an appropriate securities regulatory regime. After all, equity options, the functional equivalent of equity swaps, have always been subject to the securities laws, whether traded on-exchange or OTC. Only by making clear that equity swaps are subject to the securities laws can Congress and regulators assure that such products will not be used to circumvent the insider trading, fraud and manipulation prohibitions of those laws. It is also important that the proper margin, capital, and sales practice standards apply to these instruments, and that they be integrated into the surveillance systems applicable to other equity-based derivatives.
The NYSE has long supported exclusion of equity swaps from the CEA. Exclusion from the CEA, however, must be accompanied by clarification that these products are securities within the jurisdiction of the SEC. This clarification is necessary to seal off any possible regulatory black hole and ensure that the equity swaps market develops to meet the legitimate risk management needs of investors, not for regulatory arbitrage.
MODERNIZATION OF EXCHANGE REGULATION
The CME/CBOT proposal also seeks to modernize exchange regulation, increase exchange autonomy, and eliminate the prior approval requirements and to transform the CFTC to a supervisory and oversight agency. This portion of the proposal has many aspects but I will only touch on those that could affect the regulatory scheme applicable to existing and proposed stock index futures contracts. The NYSE has no position on any other aspects of the CME/CBOT proposal.
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As discussed earlier, the CME/CBOT proposal would have a profound effect on the designation of new stock index futures contracts. This portion of the proposal undoubtedly affects the regulatory regime under which existing stock index futures contracts are traded. Without greater detail, it is difficult to adequately assess this impact. However, the NYSE would object to any proposal that would permit futures exchanges that trade securities-based futures contracts to determine whether to opt out of: intermarket circuit breakers; Federal Reserve Board oversight of margin requirements on these products; frontrunning rules; detailed recordkeeping requirements on transactions in these products; and the current statutory audit trail requirements. We also could not support any diminution in the CFTC's ability to conduct oversight examinations of whether these requirements are being met.
Finally, I want to note that the NYSE's views on the CME/CBOT proposal are in accord with those expressed by Bill Brodsky, testifying for the U.S. Securities Markets Coalition, and Rick Ketchum, testifying for the National Association of Securities Dealers.
The securities regulatory structure has served U.S. capital markets extremely well for nearly 70 years by permitting explosive growth in those markets while protecting market integrity and investors. While we wholeheartedly support Congressional efforts to periodically re-examine this regulatory structure to make it less burdensome and more responsive to current competitive challenges, we are committed to preserving the basic regulatory structure. The CME/CBOT proposal to repeal the Shad-Johnson Accord threatens the securities regulatory structure because it has the potential to endanger investors, especially retail investors, compromise the integrity of the NYSE's market and adversely affect prices of the stocks of listed companies. Indeed, we see no economic justification for futures on individual stocks and narrow-based indices: their only purpose, it appears, would be to circumvent securities regulatory protections. For this reason, we must oppose this portion of the CME/CBOT proposal.
The CME/CBOT proposal to exclude privately, negotiated equity swaps from the CEA provides a sound starting point for achieving legal certainty for these products. With some additional work to clarify the status of these products under the securities laws, this goal could be achieved during this reauthorization. We look forward to working with CME, CBOT and the OTC derivatives community on this issue.
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Thank you for giving the NYSE the opportunity to express its views on CFTC reauthorization. We stand ready to work with the Agriculture Committee and other committees of jurisdiction as CFTC reauthorization progresses.
Testimony of Paul Saltzman
The Bond Market Association is pleased to present this testimony on issues related to the Commodity Exchange Act. The Bond Market Association represents approximately 200 banks and securities firms that underwrite, trade and sell fixed income securities in the U.S. and international markets. These firms participate in a vast array of securities and commodities markets and serve the debt capital needs of clients throughout the world. The lines of business pursued by our members are diverse. Indeed, many of our members are represented before this subcommittee by multiple working groups and trade associations.
We appear before this subcommittee today primarily in our capacity as the representative of our member firms' activities in the markets for debt securities issued or guaranteed by the U.S. Government and Federal agencies, including agency-issued mortgage-backed securities (collectively, Government securities). In that capacity, we represent all of the primary dealers who are responsible for making markets in debt issued by the U.S. Treasury. We also appear on behalf of our members' activities in the markets for over-the-counter (OTC) financial transactions relating to Government securities, as well as their funding and money market operations. Accordingly, our comments will focus primarily on the exemption from CEA jurisdiction for transactions in Government securities and other instruments under the so-called Treasury amendment.
As this subcommittee knows, the financial markets have grown increasingly complex in recent decades. Issuers of securities and other market participants have become accustomed to having a wide array of products available to meet very specific financing requirements. Unfortunately, the United States regulatory system has not kept pace with the evolution of the marketplace. Issuers, underwriters and dealers now find themselves laboring to decipher a web of overlapping and often contradictory statutes and regulations that reduce efficiency and increase costs. Of particular concern is the potential for private parties to exploit ambiguities in the CEA to abandon responsibility for otherwise enforceable contracts—even if there is no fraud or bad faith—by alleging that a transaction is an illegal off-exchange futures transaction. We know that this subcommittee, regulators and participants in these markets have an interest in ensuring the finality of financial contracts and thereby reducing potential risks to the financial system as a whole. For this reason, we commend Chairman Ewing for exploring ways to improve and update the Commodity Exchange Act.
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The Association takes an active interest in promoting and ensuring safe and efficient bond markets that allow governmental entities and corporations to raise debt capital at the lowest possible cost. Toward that end, the basic policy positions we seek to advance as Congress and the regulatory agencies deal with issues surrounding the CEA are:
preserving the finality and enforceability of contracts freely negotiated between market participants;
maintaining the OTC markets as a viable alternative to traditional organized exchanges; and
avoiding duplicative and unnecessary Government regulation.
Consistent with the above principles, we offer the following summary of our views on certain issues that are integral to the current discussion of CEA reauthorization. The Association:
supports amending the CEA to clarify that transactions—in or in any way involving—Treasury amendment instruments are exempt from the CEA;
further supports clarifying that the term ''board of trade'' as used in the CEA refers to an organized, centralized exchange market, as discussed in more detail below;
supports updating the Treasury amendment to reflect developments in the financial markets since 1974 and to accommodate future evolution and innovation;
opposes expanding the antifraud jurisdiction of the Commodity Futures Trading Commission over Government securities, which have been the subject of Securities and Exchange Commission antifraud jurisdiction for more than 60 years; and
recommends consideration of limitations on the ability of private parties to rescind otherwise enforceable contracts.
II. OVERVIEW OF THE MARKET FOR GOVERNMENT SECURITIES AND OTHER OTC DEBT INSTRUMENTS
The United States Government securities The term *government securities* is defined in Section 3(a)(42) of the Securities Exchange Act of 1934 to mean:
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(A) securities which are direct obligations of, or obligations guaranteed as to principal or interest by, the United States;
(B) securities which are issued or guaranteed by corporations in which the United States has a direct or indirect interest and which are designated by the Secretary of the Treasury for exemption as necessary or appropriate in the public interest or for the protection of investors;
(C) securities issued or guaranteed as to principal or interest by any corporation the securities of which are designated, by statute specifically naming such corporation, to constitute exempt securities within the meaning of the laws administered by the Commission; or
(D) for purposes of Sections 15C [Government Securities] and 17A [Systems For Clearance And Settlement], any put, call, straddle, option, or privilege on a security described in subparagraph (A), (B) or (C) other than a put, call, straddle, option, or privilege--
(i)that is traded on one or more national securities exchanged; or
(ii)for which quotations are disseminated through an automated quotation system operated by a registered securities association.
market is the most liquid and efficient securities market in the world. The volume of outstanding marketable Treasury securities (bonds, notes, and bills) is approximately $3.4 trillion. On an average trading day, about $225 billion in Treasury securities changes hands. The size and remarkable liquidity of the Government securities market provide market participants with confidence that they may enter and exit the market at any time. The issuance and distribution process for Treasury securities is supported by the *when issued* market, which functions to create a market for trading a new Treasury issue in the period immediately prior to its issuance. There is a period of up to two weeks between the time a new Treasury issue is announced and the time it is actually issued. The Treasury permits trading during this period, and the issue is said to trade *when, as, and if issued.* *When issued* trading serves as a critical price discovery mechanism, reduces uncertainties surrounding Treasury auctions, and thus, adds to the liquidity and efficiency of the underlying market.
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As a result, market participants are willing to accept a lower rate of return on their investments, which keeps borrowing costs as low as possible for the Federal Government and, in turn, for American taxpayers.
The broader debt capital markets also use Treasury securities as their benchmark. Thus, rates on Treasury securities directly influence interest rates for home mortgage loans, consumer and college loans, and business financing. Maintaining the efficiency and liquidity of the Government securities market not only is essential to minimizing the cost of funding Federal activity, it is essential to the nation's economy as a whole.
In addition to Treasury securities, the Government securities market includes securities issued or guaranteed by Federal Government agencies and Government-sponsored enterprises, such as securities of the Farm Credit System, the Federal Home Loan Bank System, the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and Student Loan Marketing Association, and securities guaranteed by the Government National Mortgage Association. Agency debt outstanding amounts to more than $1.1 trillion. The efficiency and liquidity of the market in these securities has served to support rural and agricultural credit, lower borrowing costs for home buyers, and finance student loans.
In addition to raising capital for their own charter needs, the Federal agencies, particularly Fannie Mae, Freddie Mac and Ginnie Mae, also play integral roles in the market for mortgage-backed securities (MBSs) by issuing mortgage pass-through certificates and other financial instruments backed by mortgage loans. MBSs enlarge the pool of capital available for mortgage lending by overcoming two obstacles to the trading of actual mortgage obligations: credit and liquidity. Agencies guarantee the credit on groups of mortgages, allowing them to be purchased with more confidence that they will provide consistent cash flows. Once the mortgages are pooled, they can then be securitized—rights to the cash flows from the mortgages can be sold to investors in the form of MBSs. Like the when issued market for Treasury securities, transactions in these instruments have been developed that, as a matter of market practice and regulatory sanction, often settle on a delayed delivery or forward basis.
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As the debt securities markets have evolved over the years, a number of instruments and transactions have been developed by dealers to assist in the financing of Treasury and other Government securities, as well as other debt financing. For example, repurchase agreements (repos) play a key role in enhancing liquidity in the U.S. fixed income markets generally. Repos involve the sale of an underlying instrument, executed along with a forward-settling agreement to buy back the asset. These transactions are economically similar to secured financing arrangements. The use of repos reduces borrowing costs for the U.S. Treasury and other market participants, provides a vital element of price discovery, and significantly contributes to liquidity in the cash markets. Moreover, the Federal Reserve Bank of New York uses repos as its primary tool for implementation of U.S. domestic monetary policy. The size of the repo market reflects its importance: the average volume of repos and reverse repos outstanding among primary dealers in Government securities is over $2.5 trillion.
Various other OTC financial transactions involving forwards, options, swaps, and other instruments, such as structured notes, also have become important financial tools, particularly as hedging vehicles or capital raising techniques in their own right, which significantly contribute to the efficiency of the underlying debt capital markets discussed above and help reduce the cost of capital for businesses and governments. Market participants generally use these types of instruments to protect themselves against risk from changes in the value of the underlying asset—which translates into a lower cost of capital.
III. REGULATION OF THE GOVERNMENT SECURITIES MARKET
It is important to note that the Government securities market not only is the most liquid and efficient securities market in the world, it is one of the most highly regulated. The SEC has had antifraud authority over transactions in Government securities since 1934. As discussed below, there is no gap in Government securities market regulation that needs to be filled.
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The Government Securities Act of 1986 was enacted specifically to regulate Government securities dealers. The GSA required all Government securities dealers to register as dealers or file notification with their existing regulators, instituted financial responsibility requirements for Government securities dealers, and provided additional safeguards for customers. These requirements were adopted after extensive hearings by Congress and reports by the Department of the Treasury, the Board of Governors of the Federal Reserve System, the banking regulators and the SEC. The Association, then known as the Public Securities Association, worked closely with these agencies and with Congress in the development of the GSA.
In 1993, Congress adopted the Government Securities Act amendments of 1993 (the 1993 amendments) to reauthorize certain authorities under the GSA and to add new requirements, including large position reporting. The new law required all Government securities brokers and dealers to furnish transaction records to the SEC on request and clarified the SEC's authority over fraudulent and manipulative practices under the Securities Exchange Act of 1934. The 1993 amendments also granted authority to the National Association of Securities Dealers to establish sales practice rules and gave identical authority to bank regulators in the case of bank dealers. We worked with Congress throughout the development of the 1993 amendments, and, subsequently, we have worked extensively with the regulators in the development of rules authorized by the new law to ensure a balanced and tailored approach to regulation of the Government securities market.
The above regulatory regime evolved over many decades and, in the final years of its development, was the product of intense negotiation and compromise by all interested parties. We believe the existing statutory framework represents a balanced approach to securities regulation that allows the market to function smoothly while still protecting participants from fraud and manipulation.
IV. SCOPE OF THE TREASURY AMENDMENT
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Under current law, the Treasury amendment provides:
Nothing in this Act shall be deemed to govern or in any way be applicable to transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, Government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade. 7 U.S.C. 2(ii).
This exclusion was recommended by the Department of the Treasury, and included in the CEA, when the CFTC was created by Congress in 1974. In proposing the provision, the Treasury sought to protect the markets in foreign currency, Government securities and other enumerated instruments from unnecessary and potentially harmful regulation by the CFTC, unless these instruments involve contracts of sale for future delivery traded on an organized exchange.
A.''In or involving.''In February of 1997, the Supreme Court ruled in Dunn v. CFTC 519 U.S. 465 (1997).
that the current exemption for transactions in foreign currency encompasses all transactions relating to foreign currency, or, alternatively stated, all transactions in which foreign currency is the fungible good whose fluctuating market price provides the motive for trading. Although questions have not arisen about the exempt status under the Treasury amendment of options on Government securities, Congress addressed certain jurisdictional issues applicable to the securities and futures markets in 1983, in adopting Section 2(a)(1)(B) of the CEA as part of the *Shad-Johnson Accord,* which provided, among other things, that the CEA does not apply, and the CFTC has no jurisdiction, to designate a board of trade as a contract market for options on one or more securities. The law permitted the trading of futures on indices of securities meeting specified requirements and also permitted the trading of futures on individual government securities.
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we support efforts to remove any ambiguity by amending the statute to exempt transactions in or in any way involving the enumerated instruments. Indeed, apart from options on Government securities, the regulatory status of which is well settled, there are numerous other instruments and transactions that provide for delayed delivery or are otherwise forward settling, such as the repurchase obligation in a repo. Although probably without merit, counterparties wishing to walk away from their obligations could question the legality of these instruments under the CEA if the language is not clear. Many of these instruments and transactions, as described above, are essential to providing liquidity for the underlying instruments.
B. ''Board of Trade.'' The phrase board of trade is currently defined in the CEA, 7 U.S.C. 1a(1).
but has been the subject of uncertainty and litigation. Clarifying the definition of this term is particularly important, because a finding that an OTC transaction in an instrument otherwise excluded under the Treasury amendment is a transaction...for future delivery conducted on a board of trade makes the transaction subject to the CFTC's exclusive jurisdiction and an illegal off-exchange future, unless traded on a designated contract market or otherwise exempted. Such a finding in effect enables private parties to rescind otherwise enforceable contracts.
We believe certain aspects of the general definition of board of trade/organized exchange should be clarified. For purposes of the Government securities marketplace, we view an organized exchange as meaning a corporate entity, owned by participating members, primarily engaged in the business of offering its members a centralized physical facility to enter into standardized non-negotiable contracts on a physical trading floor or using a formal market maker system, central limit order book, or single price auction, that is designed to provide continuous two-sided quotations, and centralize its members trading activity in one location. Additionally, an organized exchange is designed to create a reasonable expectation among its members that they can regularly execute orders for the standardized contracts at quoted prices, and then clear and settle those contracts with other members using facilities of the exchange.
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We would be concerned if board of trade or organized exchange (transactions on which, as noted, do not have the benefit of the Treasury amendment exclusion) were defined to include electronic trading facilities An expansive definition of board of trade which includes electronic trading facilities would have the effect of triggering the exception to the Treasury Amendment's exclusion from CEA coverage for transactions in or in any way involving government securities in circumstances where the facility is subject to supervision by the SEC as a broker, dealer, securities exchange or clearing corporation under the *34 Act. Accordingly, language should be carefully crafted to avoid interpretations that could lead to duplicative regulation in this area.
or to include situations where market participants conduct transactions in a screen-based format and settle them through an independent clearing mechanism. These facilities and mechanisms may take on certain functional characteristics of an organized exchange. For example, a large segment of the Government securities markets trades through an established network of inter-dealer brokers that may utilize the services of SEC-registered clearing corporations The Government Securities Clearing Corporation (*GSCC*) provides automated trade comparison, netting, and settlement for government securities. GSCC is owned and governed by member firms and is an affiliate of the National Securities Clearing Corporation. MBS Clearing Corporation provides clearing and depository services for transactions among participants in the market for MBSs. MBSCC is a wholly-owned subsidiary of the Midwest Stock Exchange. Its clearing division provides trade recording of forward contracts in GNMA, FNMA and FHLMC securities and netting of such contracts. The Participants Trust Company (PTC) is an intermediary in the process of transferring monthly principal and interest payments to GNMA investors.
that provide comparison and netting services roughly comparable to services provided by organized exchanges. These activities, conducted through entities that are registered with the SEC (but not as securities exchanges) should not be considered a board of trade or organized exchange under the CEA, and they do not fall through any regulatory gap. Any effort to include these traditional OTC markets within the jurisdiction of the CEA would create significant market uncertainty and disruption and would be strongly opposed by the Association.
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For the above reasons, we recommend amending the CEA to include express statutory language stating that, whatever the definition of board of trade or organized exchange, the activities of regulated market participants active in the Government securities market are excluded.
V. TREATMENT OF GOVERNMENT SECURITIES
As noted earlier, the SEC has had antifraud jurisdiction over transactions in Government securities for more than 60 years. Government securities brokers and dealers, banks, and other registered broker dealers are subject to a comprehensive regulatory scheme that involves supervision by banking regulators and the SEC, financial responsibility rules, customer protection and sales practice rules, and numerous other requirements established when Congress passed legislation governing this market in 1986 and again in 1993.
We would oppose any effort to grant the CFTC antifraud jurisdiction over Government securities transactions. It would be duplicative and therefore unnecessary due to the existing antifraud and enforcement authority residing in the SEC. We believe, for the reasons stated above, there should be a total exclusion from regulation by the CFTC of transactions in or in any way involving Government securities, unless they involve the sale for future delivery on a board of trade designated by the CFTC as a contract market.
VI. RECISION REMEDIES
For your further consideration, we ask the subcommittee to revisit a provision of the CEA that effectively gives a party the right to rescind a contract if the party is successful in alleging that the transaction was actually an illegal off-exchange future. Under the CEA, OTC commodity futures transactions are per se illegal unless they are excluded by the Treasury amendment or some other exemption; private parties have taken the position that such transactions are subject to recision. This harsh consequence of voiding an otherwise enforceable agreement is particularly troublesome in light of the difficult interpretive questions associated with defining a future versus a forward transaction. We believe the financial markets should not be subject to the risks posed by the potential abandonment of contract obligations when the CEA status of a financial transaction is challenged. Congress previously has recognized the harshness of recision as a remedy. Truth in Lending Act Amendments of 1995, Pub. L. No. 104-29, 109 Stat. 271.
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During the CEA reauthorization process, Congress should consider whether recision is an appropriate remedy when definitional ambiguities in the statute can be exploited by a party who simply finds itself on the losing side of a financial transaction.
The Association thanks the subcommittee for the opportunity to testify on this important subject. We would be pleased to work with the subcommittee as it considers our comments and the comments of others during the reauthorization process.
Statement of Edward Rosen
Chairman Ewing, members of the subcommittee, this testimony is submitted by Edward Rosen, a partner with Cleary, Gottlieb, Steen & Hamilton, on behalf of an ad hoc coalition of investment and commercial banks. The Coalition is comprised of the following institutions:
The Chase Manhattan Bank, Citigroup Inc., Credit Suisse First Boston Inc., Goldman, Sachs & Co., Merrill Lynch & Co., Inc. Morgan Stanley Dean Witter, Inc.
This Coalition is grateful for the opportunity to present the Subcommittee with the Coalition's views regarding the reauthorization of appropriations to fund the operations of the Commodity Futures Trading Commission under the Commodity Exchange Act. The Coalition supports the Subcommittee 's efforts to ensure that the CEA keeps pace with developments in the financial markets.
I. The Coalition. The six Coalition firms are major participants in all of the country's financial markets, including the securities markets, government securities markets, foreign currency markets, futures markets and derivatives markets. These firms are in the forefront of financial product innovation and compete globally with non-U.S. financial institutions for international business in all financial markets.
These firms have established the Coalition for one purpose: to present to Congress a consensus, market-sensitive view on necessary revisions to the CEA. As participants in all financial and derivatives markets, and as important members of nearly every major trade association affected by the CEA, this group is able to provide a singular perspective that cuts across product lines and reflects the integrated character of the global markets for these products.
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The Coalition welcomes and endorses the Subcommittee's reexamination of the CEA. Any statute that regulates activity in arenas that are as fast paced and critical to the economic well-being of this nation as our financial markets must be reexamined from time to time in light of the evolving needs of the markets and market participants.
The Coalition commends the members of this Subcommittee in particular for their leadership role in addressing these issues.
IL Overview of the Coalition 's Objectives. The Coalition believes there is a pressing need to accomplish two objectives in the reauthorization process:
To provide legal certainty for over-the-counter derivatives transactions and hybrid instruments, and To eliminate the significant barriers to financial innovation that currently exist under the CEA.
In its current form, the CEA creates legal risks that do not exist in other jurisdictions and erects barriers to the use of evolving financial market technologies. As a result, the CEA makes the United States less attractive as a financial center, reduces the competitiveness of the U.S. financial sector vis-a-vis foreign financial institutions and limits the ability of U.S. companies in all sectors of the U.S. economy to make use of desirable financial innovations.
The Coalition is not suggesting, however, that Congress must entirely rewrite the CEA in order to address these problems. It is not necessary that Congress do so because the CEA was designed to address policy concerns that are not raised by OTC derivative instruments and hybrid instruments. Specifically, the CEA was enacted to safeguard important price discovery markets and prevent manipulation in markets involving the physical delivery of commodities under standardized contracts. The CEA should continue to foster these policy objectives.
The Coalition instead urges that Congress confirm and clarify that qualifying OTC derivative instruments and hybrid instruments—whether based on interest rates, securities or any other asset, rate or index—are not subject to regulation under the CEA. That simple step alone would provide these transactions with much needed legal certainty, without any need for far reaching modifications to the CEA. By taking that step, and simultaneously removing barriers to the use of electronic trading systems and new clearing mechanisms, Congress will have eliminated significant impediments under the CEA to financial innovation.
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A. Legal Certainty. Legal uncertainty continues to affect OTC derivative instruments and hybrid instruments, despite previous efforts by Congress and the CFTC to clarify that the CEA's ban on off-exchange futures trading does not apply to these instruments.
Congress first attempted to bring legal certainty to OTC transactions in the context of foreign currencies and government securities in 1974 by enacting the Treasury Amendment. Subsequently, in 1992, Congress enacted the Futures Trading Practices Act and included provisions designed to bring legal certainty to qualifying swap transactions and hybrid instruments.
However, for a variety of reasons, these transactions remain subject to unacceptable legal uncertainty and limitations on the scope of transactions that may be conducted under the CEA. This is particularly true in the context of transactions involving non-exempt securities, such as corporate stocks and bonds.
This continuing legal uncertainty comes at a cost. Legal risk is the only type of risk that Wall Street 's risk management professionals cannot affirmatively manage. As a result, U.S. financial institutions may reduce legal risk either by discontinuing affected transactions entirely or by conducting as much of the activity as possible outside the United States.
Foreign companies, who represent a majority of the market for OTC derivative instruments in many product categories, can avoid legal risk by transacting with European and Asian financial institutions, rather than U.S. institutions. The eventual consequence of these actions will be to reduce the attractiveness of U.S. financial centers and to cede U.S. leadership in the field of risk management to foreign competitors. Moreover, if the focus of derivatives activity moves to financial centers outside the United States, U.S. policy makers will lose influence over the evolution of regulatory policy with respect to these vital markets.
Derivatives dealers and their counterparties are not the only ones exposed to legal risk. Had the legal uncertainties affecting OTC derivative instruments come home to roost during the events surrounding LTCM, the consequences of market volatility might not have been as well contained. Congress should make no mistake, preserving the status quo is unquestionably not the safest course of action.
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There is an overwhelming consensus among financial market participants across a broad spectrum of product segments that legal certainty for OTC derivative instruments and hybrid instruments must be a top Congressional priority for CFTC reauthorization. These issues must be resolved and cannot continue to be held hostage to the satisfactory resolution of other, in some cases more controversial, issues in reauthorization.
The actions of the CFTC last year only increased legal uncertainty and heightened market concerns regarding the risks associated with the conduct of business in the United States. Those actions demonstrated beyond question that it is only Congress that can take the steps necessary to address these issues and, concomitantly, that Congress must, at last, act to address these issues.
B. Elimination of Barriers to Innovation. The CEA currently inhibits U.S. firms from taking advantage of technological and financial innovations, such as clearing and electronic trading, that would increase the efficiency of trading and reduce systemic risk. The CEA incorporates a regulatory framework and a philosophy that are ill-equipped to accommodate these important innovations. Rather than providing firms with clear guidance as to the range of activities that would be permitted, the CEA prohibits activities that have not been otherwise approved by the CFTC. The inevitable result is bureaucratic delay and micromanagement that is inimical to the potential benefits of technological and financial innovation. Consequently, these innovations are to a large extent being developed in jurisdictions outside the United States.
Clearing and electronic trading undeniably represent the future for the global financial markets. As a result, Congress confronts a stark choice: either modify the existing framework of the CEA so that U.S. firms can participate in and benefit from these innovations or maintain the status quo and facilitate the surrender of U.S. leadership in financial innovation to our foreign competitors.
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In addition, by preventing U.S. firms from taking advantage of innovations that reduce counterparty credit risk, the CEA actually increases systemic credit risk without producing any countervailing regulatory benefit. Congress simply cannot countenance this result.
III. OTC Derivative Instruments. Congress recognized the potential benefits of OTC derivative instruments from the earliest stages and has played a vital role in encouraging their development through legislation. Congress understood from the outset that the public policy concerns that motivated enactment of the CEA, primarily protecting against price manipulation and customer abuse by intermediaries, are simply not raised by OTC derivative instruments. Based on a consensus among Congress, Federal financial regulators and market participants that OTC derivative instruments are not appropriately regulated under the CEA, Congress enacted legislation empowering the CFTC to grant administrative relief for these products. As the tremendous growth in OTC derivatives activity demonstrates, the combined efforts of Congress and Federal financial regulators to enhance legal certainty for these products has met with great success.
In recent years, however, the legal status of these products has become murkier. New products have evolved that do not fit neatly into the parameters of existing exemptions. In addition, actions and public statements by the CFTC over the past year have cast doubt on the scope of the existing exemptive relief applicable to these products.
Due to a provision in the Shad-Johnson jurisdictional accord between the CFTC and the SEC, legal uncertainty is particularly acute in the context of OTC derivative instruments involving non-exempt securities.
At the time the Shad-Johnson Accord was concluded, it was viewed as a temporary solution to an interagency jurisdictional dispute. Neither the CFTC, the SEC nor Congress anticipated that the accord would become a source of legal uncertainty for OTC derivative instruments involving non-exempt securities. In 1992, when Congress enacted the FTPA, it codified the Shad-Johnson Accord because it was unable to resolve the outstanding interagency issues. However, the Conference Committee expressly stated in the Conference Report that it had no intention of calling the legal status of these transactions into question.
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It is unacceptable for jurisdictional disputes between regulators to give rise to legal risk. It is time to move beyond temporary solutions and provide the necessary degree of legal certainty for these instruments.
IV: Hybrid Instruments. As Congress has recognized, hybrid instruments that are predominantly securities or bank products are not appropriately regulated under the CEA. The principal regulatory challenge presented by hybrid instruments is not to prevent commodity price manipulation but, as is the case with more traditional securities, to ensure the adequacy of disclosure regarding the economic performance of and risks associated with the investment.
The CEA, however, was designed to protect markets against price manipulation and fraud, not to facilitate disclosure of material information to the capital markets. By contrast, disclosure is at the heart of the Federal securities laws. Moreover, hybrid instruments are not used as a pricing mechanism for the general price discovery process of the underlying commodity and thus cannot be used to manipulate commodity prices. Accordingly, hybrid instruments are more appropriately regulated under the securities and banking laws than under the CEA.
Despite these public policy ramifications, the CEA may apply to certain hybrid instruments because they may be viewed as incorporating an embedded futures contract or commodity option. As a result, Congress directed the CFTC to issue an exemption from the CEA for hybrid instruments that are ''predominantly'' securities or depository instruments, rather than futures or commodity options. The so-called ''predominance test'' that the CFTC formulated reduces even further the risk that hybrid instruments may be used as a vehicle for commodity price manipulation. Although very complex and not easily understood by nonprofessionals, the CFTC's hybrid exemption and statutory interpretation have created practical standards for the banks and securities firms who develop these products.
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Hybrid instruments involving non-exempt securities are similarly subject to greater legal uncertainty than other hybrid instruments. It is ironic that under Federal commodities regulation, hybrid instruments involving securities would be subject to greater constraints than those involving physical commodities.
V. Treasury Amendment. In enacting the Treasury Amendment, which excludes OTC derivative instruments involving government securities and foreign exchange from regulation under the CEA, Congress agreed with the Treasury Department that there is no need to regulate financial products that are primarily traded among banks, dealers and sophisticated institutions in off-exchange transactions. In addition, Congress recognized that broad, liquid and efficient markets in government securities and foreign exchange were vital to the national interest and that potential application of the regulatory constraints of the CEA to these markets would be unnecessary and inappropriate.
However, the scope of the Treasury Amendment has been repeatedly challenged by the CFTC over the years. These challenges have given rise to unnecessary legal uncertainty. The Treasury Amendment excludes from regulation under the CEA certain transactions, unless they are conducted on a ''board of trade.'' Although standard usage and the legislative history suggest that Congress intended the term ''board of trade'' to mean ''organized futures exchange,'' subsequent interpretations by the CFTC and a few courts have generated confusion over the meaning of the term. In turn, the potential application of the CEA has created legal uncertainty for OTC derivative instruments involving government securities and foreign currencies. This confusion has adversely affected the use of electronic trading systems and clearing mechanisms in particular. Congress should alleviate this uncertainty by clarifying its original intent that the term ''board of trade'' means ''organized futures exchange.''
The markets for foreign exchange and government securities have evolved since the 1974 enactment of the Treasury Amendment. As a result, the list of excluded products should be clarified to reflect the evolving character of these markets.
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VI. Electronic Trading. Both exchange markets and OTC markets are rapidly adopting electronic trading systems to enhance efficiency and reduce costs. This trend will continue and intensify. The current CFTC exemption for swaps constrains the use of such trading systems. Questions have also been raised, in our view without justification, as to whether the Treasury Amendment excludes transactions conducted on an electronic trading system.
The CEA and CFTC regulations effectively do not accommodate the development of electronic trading systems except as part of a U.S. futures exchange. This situation is untenable in today's markets, and Congress must consider whether any public policy goal is being served by this result. Electronic trading systems not only produce operational and cost efficiencies, they enhance the fairness and transparency of markets and reduce the need for regulation. Federal regulatory policy should encourage the development of such systems and should not stand, like the CEA, as an obstacle to their implementation. The CEA must therefore be amended to encourage the use of electronic trading systems.
There are many different types of electronic trading systems, and not all of them replicate the fundamental attributes of an organized futures exchange. Accordingly, the CEA should incorporate a flexible approach to these systems differentiating among those that do not require regulation, those that require regulation as an exchange and those that perhaps merit some regulation, although less extensive regulation than an exchange, in each case depending on the nature and characteristics of the system.
Finally, it is not obvious that regulation of an electronic trading system for OTC transactions that are futures must be performed exclusively by the CFTC. Depending on the nature of the products traded on the system, geographic considerations or other factors, it may be more appropriate for the CFTC to rely on the regulation of the system by another appropriate U.S. or G–7 regulator.
VII. Clearing. In order to address and mitigate credit risk, the financial markets are increasingly exploring ways to expand the availability of clearing mechanisms for OTC derivative instruments. Clearing mechanisms take many forms and do not necessarily resemble traditional futures clearing. As in the case of electronic trading, the CFTC's current exemption for swaps constrains the use of many forms of clearing arrangements to mitigate credit risk. Questions have also been raised, again, in our view without justification, as to whether the Treasury Amendment excludes transactions that are subject to clearing arrangements.
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Therefore, parties wishing to use a clearing facility must apply for a specific exemption from the CFTC. This is not only a costly and time-consuming prospect, but the CEA does not even contemplate the existence of a clearinghouse independent of a futures exchange, further complicating the prospects for appropriate agency action. Thus, although, clearing is a means of reducing risk, the CEA and CFTC regulations create obstacles to the expanded use of clearing mechanisms for OTC derivatives transactions. The result has been that clearing facilities are being developed
in foreign jurisdictions whose regulatory schemes accommodate, rather than impede, such innovations.
Regulatory oversight of certain clearing facilities may well be prudent from a policy perspective, and the Coalition is not opposed to such oversight in appropriate circumstances. However, the existence of a clearing mechanism for OTC derivatives transactions itself should not have the effect of subjecting the entire range of cleared OTC activity to CFTC regulation, a position the CFTC could adopt under current law. It is similarly not obvious that regulation of clearing mechanisms for OTC transactions that are futures must be performed exclusively by the CFTC. Depending on the nature of the cleared products, geographic considerations or other factors, it may be more appropriate for the CFTC to rely on the regulation of a clearing system by another appropriate U.S. or G–7 regulator.
VIII. Derivatives Dealers. The Coalition does not believe that additional regulation for OTC derivatives dealers is necessary. The vast majority of OTC derivatives dealers are banks subject to regulation by the Board of Governors of the Federal Reserve System or the Office of the Comptroller of the Currency, broker-dealers subject to oversight by the Securities and Exchange Commission or affiliates of regulated securities firms who are subject to risk assessment by the SEC and who adhere to the Derivatives Policy Group's ''Framework for Voluntary Oversight.''
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No case has been made that additional specific regulation of these firms is necessary or would provide any significant benefit. Market discipline has generally had a significant positive impact on participants in these markets. Although the events of last year demonstrate that there have been private sector lapses in credit risk management discipline, these weaknesses were not in any way associated with the presence or absence of Federal oversight. On the other hand, adding a new layer of Federal regulation of these dealers would be unnecessary, in many cases duplicative, and burdensome.
IX. Recommended Actions. In order to address the issues described above, the Coalition respectfully recommends that Congress take the following actions:
OTC Derivative Instruments. Exclude qualifying OTC derivative instruments between eligible counterparties from regulation under the CEA. For these purposes, ''qualifying'' transactions should include any category of principal-toprincipal OTC transactions that are not part of a fungible class of instruments that are freely transferable without counterparty consent or subject to automatic rights of offset through transactions with third parties.
Hybrid Instruments. Exclude hybrid instruments from regulation under the CEA, based on the ''predominance'' test articulated in the CFTC's existing exemption for hybrid instruments and statutory interpretation concerning hybrid instruments.
Shad-Johnson. Clarify that these exclusions for OTC derivative instruments and hybrid instruments apply equally to transactions involving non-exempt securities.
Clearing. Clarify that qualifying OTC derivative instruments may be cleared without subjecting transactions in those instruments to regulation under the CEA.
Electronic Trading. Clarify the circumstances under which OTC derivative instruments may be traded on electronic trading systems.
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Treasury Amendment. Clarify that the Treasury Amendment applies to all transactions involving the enumerated list of financial products that are not conducted on an organized futures exchange -whether or not the transactions are subject to clearing arrangements or conducted on an electronic trading system -and further clari@the scope of financial products covered by the Treasury Amendment.
X. Conclusion. The CEA and the markets overseen by this Subcommittee have historically, and with justification, been a source of pride for this Subcommittee. Today, however, the statute is both badly out of sync with the markets it purports to govern and casts a long shadow over markets it was never intended to govern.
The CEA has become a true legislative irony. If asked, most legislators would say that the objective of financial regulation is to enhance the safety of the markets by reducing the risks associated with regulated activity. The CEA, however, makes the world today a more risky place than it would otherwise be. And worse, the CEA stands as an obstacle to private sector initiatives to mitigate the risks that are endemic to our free market economy.
We have attempted for nearly ten years to address these issues under the CEA. We made important progress in the Futures Trading Practices Act of 1992, but were unable to effect all the changes necessary to resolve these issues definitively. We failed in efforts in 1997 to resolve these issues. In 1998, the OTC derivatives markets in the United States had what many have regarded as a near-death experience—averted in large part by the timely intervention of members of this subcommittee.
The failure to successfully address these issues in the past has often not had anything to do with objections to the goal of providing legal certainty. Instead, legal certainty has been used as a bargaining chip in an attempt to extract support for other legislative concessions. This strategy can no longer be tolerated. Issues must be addressed on their merits. Progress on legal certainty can no longer be held hostage to other objectives. If Congress must solve every problem as a condition to solving any problem, we have a long term recipe for regulatory gridlock.
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Many issues have been identified by the parties interested in CFTC reauthorization. Some of the proposals that have been advanced raise complex and controversial issues. The solution to legal uncertainty, however, is clear: Congress must take the straightforward steps necessary to address this issue. If the events of last year demonstrated anything, it is that Congress can no longer tolerate the risks that are associated with continued inaction in this area.
We similarly cannot continue to permit the CEA to stand as an obstacle to the implementation of important new technologies and risk-reducing mechanisms or as a catalyst to the migration of financial services to foreign financial centers.
It is important to recognize all that is at stake by inaction. The more outdated the CEA is permitted to become, the greater the likelihood that it will ultimately become irrelevant. If Congress continues to miss opportunities to modernize the CEA, the United States will forfeit its position as a leading global financial center and the U.S. legislative and regulatory community will significantly diminish its own influence over the development of regulatory policy with respect to the global financial markets.
The Coalition very much appreciates the Subcommittee's interest in these issues, and we are committed to, and look forward to, working with the subcommittee and other interested parties in an effort to solve these problems.
Statement of Joseph B. Bauman
This statement is submitted by the International Swaps and Derivatives Association, Inc. to the House Subcommittee on Risk Management and Specialty Crops in connection with the subcommittee's May 18–20, 1999 hearings on the Commodity Exchange Act and reauthorization of the Commodity Futures Trading Commission.
ISDA is an international organization whose membership includes more than 400 of the world's largest commercial, merchant and investment banks and other corporations and institutions that conduct significant activities in swaps and other privately negotiated derivatives transactions (collectively, ''swap transactions''). Moreover, ISDA's dealer-members are among the principal customers of the regulated futures exchanges. The issues to be addressed in these hearings are of great importance to ISDA's members and ISDA welcomes the subcommittee's invitation to testify.
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I. Need for CEA Reform
ISDA believes that the time has come to modernize the CEA. The objectives of modernization should be to provide legal and regulatorys certainty for financial contracts, to encourage financial innovation and to facilitate competition in the United States and abroad. A modernized CEA should foster efficient, liquid and low cost financial transactions. Regulatory burdens that increase the cost or availability of essential risk management tools to America's businesses and other end-users should be imposed only in those cases where less burdensome means, including market discipline, have not been effective. Congress should also recognize that America's businesses benefit when they can choose among different risk management tools and that the continued development of a diverse array of these tools will be enhanced by different regulatory structures, including private regulation through market discipline.
There are a number of actions that Congress should take to achieve these broad policy goals for CEA reform. First, Congress should clarify once and for all that the CEA does not apply to swap transactions. In addition, broad regulatory relief should be provided to the organized futures exchanges to the maximum extent Congress concludes that it would be prudent to do so. ISDA and its members would welcome legislation that modernizes exchange regulation, increases the autonomy of the exchanges, and enables them to move promptly to offer a broad array of low cost risk management products.
As discussed more fully in this statement, ISDA has been particularly concerned with the legal uncertainties relating to the status of swap transactions under the CEA. Swaps and related off-exchange transactions serve important economic and risk management functions. Swap transactions are custom tailored to meet the unique needs of individual firms. Due to the tailored nature of such transactions, swap transactions differ substantially from the standardized exchange-traded futures contracts governed by the CEA. As a result, swap transactions cannot fit within the regulatory framework defined by the CEA. In fact, the CEA is an inappropriate framework for the regulation of swap activity to such an extent that, if that framework were imposed on these contracts, the exchange trading requirements of the CEA would instantly call into question the enforceability of thousands of swap transactions and put at risk tens of billions of dollars of value on the books of American banks, brokers and corporations.
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Historically, the CFTC has recognized this fact and acted to make it clear that swap transactions are not appropriately regulated under the CEA, by issuing the 1989 Swaps Policy Statement and 1993 Swaps Exemption, which are discussed in detail below. Nevertheless, and despite significant efforts by Congress, the inapplicability of the CEA to these transactions has not been fully and adequately clarified. ISDA has actively supported the subcommittee in its efforts to resolve these uncertainties by modernizing the CEA.
The importance of Congressional action with respect to legal certainty and related issues was underscored by the course of action unilaterally followed by the CFTC in 1998. In a comment letter to the Securities and Exchange Commission on a new category of limited purpose securities dealer (or broker-dealer lite), in its interim final rule on agricultural trade options, and in its concept release on off-exchange derivatives, the CFTC took three major steps away from the goal that Congress, the CFTC and the industry have worked toward. These actions were harmful and increased legal uncertainty regardless of the motivation of the CFTC in taking these actions. Many parties, our members among them, were extremely concerned about the regulatory actions the CFTC has taken. We wholeheartedly supported the ''standstill'' legislation enacted in 1998 to give Congress adequate time to weigh these important issues.
II. Importance of Swap Transactions
Many corporations, financial institutions and Government entities in the United States rely on swap transactions to manage risk. Ordinary financial and commercial activities of these firms give rise to a host of risks, many of which could not be hedged or managed in an efficient manner, if at all, without the use of swap transactions. Therefore, the availability of swap transactions at low cost and within a strong legal framework in the United States is of vital interest to all ISDA members and the other institutions who rely on swap transactions. Any legal uncertainty presents a significant source of risk to individual institutions and to the financial markets as a whole and precludes the full realization of the powerful benefits such transactions provide.
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Derivatives, particularly privately negotiated swaps, are powerful tools which allow the counterparties to adjust the risk characteristics of their assets and liabilities, fine tune their risk exposures and lower their costs of capital. In such a transaction, two counterparties establish a custom-tailored bilateral agreement to exchange cash flows at periodic intervals during the life of the deal according to a prearranged formula. These cash flows are determined by applying the prearranged formula to the ''notional'' principal amount of the swap transactions. In most swaps, such as interest rate swaps, this notional amount never changes hands and is merely used as a reference for calculating the future cash flows.
For example, if a corporation has floating-rate debt outstanding and is concerned that interest rates might rise, it could use an interest rate swap to convert its floating-rate debt into a fixed-rate obligation. Similarly, if a corporation earns non-dollar revenues from a foreign subsidiary and wants to avoid the risk of fluctuating exchange rates, it could use a currency swap to hedge this exposure. Almost any kind of swap can be created. The flexibility and benefits that swap transactions provide have led to dramatic growth in the use of such transactions. In addition to interest rate and currency swap transactions, commodity, equity, credit and other types of swap transactions are widely used. Transactions take place around the globe, and U.S. institutions are leaders in this business at home and abroad.
III. Introduction to the Problems
One of ISDA's main goals since its inception has been to promote legal certainty for swap transactions. ISDA has sought to establish (i) clarity concerning how swap transactions will be treated under U.S. law and laws in other jurisdiction, (ii)—certainty that they will be legally enforceable and not subject to avoidance and (iii)—certainty that key provisions in swap transactions (including termination and netting provisions) will be enforceable, even in the case of bankruptcy of one of the parties. For example, ISDA has worked with the Congress to pass legislation establishing the enforceability of master agreement netting provisions in the case of insolvency of a U.S. counterparty. In addition, ISDA has developed model swap contracts that are used in the United States and around the world by the vast majority of swap participants for their transactions.
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The CFTC's actions in 1998 were reminiscent of previous events that have cast doubt on the legal certainty that the CEA does not apply to swap transactions. That legal certainty has been undermined on several occasions in the past decade by the structure of the CEA, which bans off-exchange ''futures'' contracts without defining the term. The statute has not easily accommodated the great innovations in financial products that have taken place since the enactment of the CEA. In 1974, Congress excluded from the CEA certain wholesale privately negotiated transactions that might otherwise have been thought to be futures. However, at that time, swap transactions did not yet exist and therefore were not specifically excluded. The resulting legal uncertainties, which will be explained in more detail below, have inhibited the evolution of swap transactions in the United States and the natural and beneficial growth in their use.
IV. History of CEA's Relationship to Swap Transactions
In 1922, Congress enacted the original version of what is now the CEA to protect farmers and other producers and merchants of certain agricultural commodities from the perceived abuses of futures contracts. The protective scheme mandated that all trading of futures contracts on certain commodities be regulated by the Department of Agriculture and conducted on organized futures exchanges (the ''exchange trading requirement''). Before trading in a particular contract may lawfully occur, an exchange must apply for and receive ''designation'' as a ''contract market'' for the trading of a particular product. However, certain exceptions to the exchange trading requirement and other provisions of the CEA exists, such as the forward contract exclusion. Considerable litigation has resulted over what transactions Congress intended to cover with this exclusion.
During the period from 1936 to 1974, the list of covered commodities was expanded periodically.
The statute was substantially revised in 1974 by (i)—establishing the CFTC to administer the CEA and regulate U.S. commodities exchanges, (ii)—expanding the definition of ''commodity'' to cover (with certain exceptions) ''all services, rights, and interests in which contracts for future delivery are presently or in the future dealt with'' 7 U.S.C. —2, CEA —1(a)(3).
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and (iii)—providing a statutory exclusion from the CEA for ''transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, Government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade'' (the ''Treasury amendment''). 7 U.S.C. —2(ii), CEA —2(a)(1)(A)(ii).
In the 1980's, the rapid growth in the use of innovative interest rate and currency swaps as well as related privately negotiated derivatives transactions to manage financial risk brought with it a desire to ensure a clear and unambiguous legal status for these transactions. In 1987, these legal concerns were significantly heightened when it was widely reported that the CFTC had commenced a formal investigation into the commodity swap business of Chase Manhattan Bank. Despite the fact that no enforcement action was ever commenced, these reports alone created significant uncertainty regarding the status of swap transactions under the CEA. It was feared that swap transactions would be deemed to be illegal and unenforceable off-exchange futures contracts. This uncertainty was exacerbated when the CFTC issued an Advance Notice of Proposed Rulemaking in which it effectively stated that transactions such as swaps which include certain elements of futures contracts may be subject to the CEA. 52 Fed. Reg. 47022 (Dec. 11, 1987).
In response to these concerns, large segments of U.S. swap activity moved offshore, and some U.S. firms ceased development of swaps entirely, reducing the ability of U.S. firms to manage risk and inhibiting the growth of these activities at U.S. institutions.
These events prompted ISDA and other industry participants to seek action by the CFTC to reduce the substantial legal uncertainty which resulted from these developments. To address these concerns, in 1989 the CFTC issued a policy statement (the ''Swaps Policy Statement'') stating its view ''that at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations [emphasis added]''. 54 Fed. Reg. 30694 (July—21, 1989).
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Thus, a nonexclusive ''safe harbor'' was extended by the CFTC to those swap transactions that met a series of tests intended to distinguish them from their exchange-traded counterparts. In order to qualify for the nonexclusive safe harbor under the Swaps Policy Statement, swap transactions, among other things, must (i)—reflect individually-tailored terms based upon individualized credit determination, (ii)—lack an exchange-style offset, (iii)—lack a clearing organization or margin system, (iv)—be undertaken in conjunction with a line of business and (v)—not be marketed to the general public.
However, the Swaps Policy Statement did not explicitly include interest rate option products. The application of the Swaps Policy Statement to interest rate caps, floors and collars was subsequently clarified in a series of no-action letters. These events were welcomed in the marketplace, and swap transaction activity expanded substantially in subsequent years. However, legal uncertainties relating to the applicability of the CEA to swap transactions remained.
These uncertainties were further heightened in 1990 as the result of a decision by a United States District Court in New York in Transnor v. BP America Petroleum, which determined that contracts for future delivery of Brent blend crude oil constituted futures contracts and were therefore subject to the CEA. 738 F. Supp. 1497. Since the Brent contracts in question were routinely settled without physical delivery by means of certain offset techniques, the court concluded that Brent contracts did not qualify for the forward contract exclusion, and then went on to determine that they were futures contracts.
Although swap transactions were not at issue in Transnor, it was feared that if another court were to apply to swap transactions Transnor's limited view of the forward contract exclusion and its expansive definition of a futures contract, and at the same time were to ignore the Swaps Policy Statement, such a court might determine that certain swap transactions were futures contracts under the CEA. The importance and potential consequences of legal risks applicable to swap transactions were subsequently brought to light in 1991 when the London Borough of Hammersmith and Fulham, which had repudiated numerous losses from swap contracts, was able to convince the House of Lords (England's highest court) that it was ultra vires to have entered into the contracts in the first instance, thereby voiding the contracts. Concern increased that similar losses could be realized in the U.S. as a result of ambiguities under the CEA.
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In 1992, Congress took a major step to provide legal certainty that the CEA was not generally applicable to swap transactions by passing the Futures Trading Practices Act of 1992 (the ''FTPA''). The FTPA provided the CFTC with the power to create exemptions from the CEA for futures contracts and transactions with futures-like elements. The Report of the Committee of Conference of the U.S. House of Representatives and the U.S. Senate for the FTPA (the ''Conference Report'') stated that the intent of this authority was ''to give the [CFTC] a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner''. H.R. Rep. No. 978, 102d Cong., 2d Sess. at 81 (1992).
In passing the FTPA, Congress specifically directed the CFTC to resolve legal uncertainty concerns by promulgating an exemption for swaps and certain hybrid contracts. In order to avoid any implication that swaps are futures, Congress expressly noted in the Conference Report that the granting of an exemption does not ''require any determination beforehand that the agreement, instrument or transaction for which an exemption is sought is subject to the [CEA]''. Id.
In response to the FTPA, the CFTC adopted an exemption for ''swap agreements'' in January 1993 (the ''Swaps Exemption''). 58 Fed. Reg. 5587 (Jan. 22, 1993).
Reflecting Congress' direction in the FTPA, the CFTC did not make any determination that swap agreements would otherwise be subject to the CEA. The Swaps Exemption exempted certain types of swap transactions, when entered into by ''eligible swap participants'', from selected provisions of the CEA, including the exchange-trading requirement. Eligible swap participants include:—banks and trust companies; saving associations and credit unions; insurance companies; commodity pools having assets exceeding $5,000,000 and meeting certain other criteria; broker-dealers; futures commission merchants; certain employee benefit plans with total assets exceeding $5,000,000; governmental entities; natural persons with total assets exceeding $10,000,000; and corporations, partnerships, trusts or other entities that satisfy certain criteria.
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Exempted transactions still must meet certain criteria that are intended to distinguish them from exchange-traded agreements. Such transactions, among other things, must (i)—not be part of a fungible class of agreements that are standardized as to their material economic terms; (ii)—involve individualized creditworthiness determinations, and (ii)—not be traded on or through a multilateral execution facility.
In general, the Swaps Exemption covers a broader range of swap transactions than does the Swaps Policy Statement.
As a result of the Swaps Exemption, even if a swap were found to be a futures contract, and none has, it would only be subject to (i)—the market manipulation and anti-fraud provisions of the CEA and (ii)—Section 2(a)(1)(B) of the CEA, which was enacted pursuant to the Futures Trading Act of 1982, otherwise known as the Shad-Johnson jurisdictional accord (the ''Jurisdictional Accord''), and which (A)—divides jurisdiction over exchange-traded derivative transactions on securities between the Securities and Exchange Commission (the ''SEC'') and the CFTC, and (B)—establishes that futures contracts on individual securities and certain narrow securities indices are illegal.
Also in January 1993, the CFTC adopted an exemptive framework for certain hybrid instruments, which provides an exemption for instruments such as equity or debt securities or depository instruments with imbedded futures or commodity option characteristics. If applicable, the exemption extends to all provisions of the CEA except the provisions adopted pursuant to the Jurisdictional Accord. Other relevant exemptions which exist include those granted for (i)—certain contracts for the deferred purchase or sale of specified energy products entered into between commercial participants meeting certain criteria and (ii)—trade options sold to commercial counterparties who are entering into a transaction for purposes related to their business.
V. Swaps Differ from Futures
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The importance of swap transactions to global commerce and finance has been well-documented. Careful tailoring of the nature, timing and amount of a transaction can insulate a swap participant from adverse movements in market prices, reduce its cost of capital or allow it to take a view on market changes. Efficiency gains are created when risks are shifted to those best able to beat them.
These useful transactions, as the Conference Report noted, ''may contain some features similar to those of regulated exchange-traded products but are sufficiently different in their purpose, function, design or other characteristics that, as a matter of policy, traditional futures regulation and the limitation of trading to the floor of an exchange may be unnecessary to protect the public interest and may create an inappropriate burden on commerce''. H.R. Rep. No. 978, 102d Cong., 2d Sess. 80 (1992).
Section 3 of the CEA describes the necessity for regulation of ''[t]ransactions in commodities... [that] are carried on in large volume by the public generally and by persons engaged in the business of buying and selling commodities and the...byproducts thereof in interstate commerce''. Section 3 notes that such ''. . . transactions and prices of commodities on such boards of trade are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed, to the detriment of the producer or the consumer . . . rendering regulation imperative for the protection of [interstate] commerce and the national public interest therein''.
Several factors clearly differentiate swap transactions from the transactions regulated under the CEA. First, such transactions are not ''carried on in large volume by the public generally''. Swap transactions are entered into on a customized, privately negotiated basis by sophisticated parties, including governments and government-sponsored entities, commercial and investment banks, corporations, and, to a very limited extent, certain individuals. Second, swap transactions are transactions in which each party assumes the credit risk of the other and thus each party requires specific knowledge about the other. The limits set forth in the Swaps Exemption preclude transactions that are standardized and fungible, i.e., transactions that are capable of being traded in large volumes. In addition, since such transactions are not standardized and fungible, they are simply not capable of being systematically traded on the floor of an exchange.
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The exemption of swap transactions from the CEA has promoted economic and financial innovation and fair competition. As stated earlier, swap transactions are used today by a large variety of entities to manage financial risks and develop new opportunities to raise capital. The growth of swap activities has been fueled by demand from these entities for new structures and refinements to address their diverse needs and the ability of swap intermediaries to develop transactions which meet those needs efficiently.
VI.Continuing Legal Uncertainties
Despite the efforts referred to above and the related subsequent legislative and regulatory pronouncements, there continue to be concerns about the legal uncertainty with respect to the inapplicability of the CEA to swap transactions. The first stems from the very nature of the Swaps Exemption as an administrative pronouncement that can be revoked or modified by the CFTC. The recent CFTC actions are evidence that this is a real concern. This leaves open the possibility that direct regulation will be imposed over swap transactions; rendering them illegal except when traded on an organized exchange and enabling parties to privately negotiated derivatives transactions to seek to avoid their contractual obligations by asserting that the transactions are illegal unless they either conform to any new or changed conditions added to the Swaps Exemption by the CFTC or are traded on an organized exchange. This could result in substantial losses to swap participants, including the loss of hedges which companies rely on to manage risk. We have previously testified before this subcommittee that even the potential for such action could cause disruption to the financial markets. Unless Congress acts, the CFTC's recent actions are likely to have this effect.
Second, the various exemptions from the CEA applicable to swaps have stated that swaps are not ''appropriately regulated'' as futures under the CEA. However, they have not established with the force of a statute that swaps are not futures. Therefore, problems could arise inadvertently, as the CFTC exercises its enforcement authority. The July 1995 enforcement proceeding against MG Refining and Marketing, Inc. and MG Futures, Inc. (the ''MG Enforcement Order'') raised such concerns. In the MG Enforcement Order, the CFTC took the opportunity to define ''all the essential elements of a futures contract'' in a way which was so broad as to encompass practically any privately negotiated cash-settled forward contract, including most swap transactions. Although the CFTC sought on two separate occasions to reassure key members of Congress and industry participants that its orders in these cases were not intended to, and did not, change the scope of the term ''futures contract'' under the CEA, MG Refining and Marketing, Inc. and MG Futures, Inc. have used the Enforcement Order to attempt to avoid their obligations under unprofitable transactions in litigation. This is an example of the negative impact legal uncertainty can have with respect to undermining the enforceability of swap transactions. Problems like this highlight the fact that the current structure of the CEA is inadequate to provide the requisite degree of legal certainty to swap participants. Repeated episodes of similar events, such as the CFTC's actions during 1998, may lead some to conclude that the United States lacks a sufficiently stable legal framework to continue to function as a center for swap transactions. In fact, the United States has become such a center as a result of the establishment of legal certainty with respect to other aspects of swap transactions, such as the enforceability of master agreement netting provisions in the case of insolvency of a U.S. counterparty.
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The possibility that some or a substantial category of privately negotiated derivatives transactions may be interpreted, even inadvertently, to be futures contracts also raises serious concerns with respect to those transactions falling outside the scope of the current or a future revised Swaps Exemption, particularly equity swaps and other swaps based on the prices of securities.
VII. Legal Uncertainties Relating to Swap Transactions Involving Securities Prices
Legal uncertainty is particularly acute with respect to credit and equity swaps. As discussed above, the CEA prohibits the entering into of futures contracts, unless made on or subject to the rules of an approved futures exchange. Therefore, any financial transaction that is a futures contract must either be (i)—transacted on an approved board of trade or (ii)—exempted from the exchange trading requirement by the CFTC. The CFTC has the power to exempt certain types of financial transactions from the requirements of the CEA under the FTPA, and promulgated the Swaps Exemption based on this authority. The FTPA, however, limits the exemptive authority of the CFTC by prohibiting the CFTC from exempting any futures contracts from the provisions of the Jurisdictional Accord.
Pursuant to the Jurisdictional Accord, the CFTC may not designate a board of trade for futures contracts on individual securities and certain narrowly defined securities indices, and since the CFTC can not issue an exemption for such futures contracts, such futures contracts are essentially illegal. Under the Jurisdictional Accord, the CFTC and SEC were granted jurisdiction, respectively, over futures and securities; futures contracts based on a group or index of securities are treated like other futures contracts under the jurisdiction of the CFTC (i.e., they must be traded on an exchange) and jurisdiction over options on individual securities was granted exclusively to the SEC. As a result, the Swaps Exemption does not cover transactions that are proscribed by the Jurisdictional Accord, and the conclusion that those transactions will not be regulated as futures must instead rest on the Swaps Policy Statement, which provides comfort that transactions within its limit are not ''appropriately regulated'' as futures contracts. To the extent, however, that swaps ever are deemed to be futures contracts, even inadvertently, (i)—swaps on single securities and certain narrow indices or groups of securities could be rendered illegal under the Jurisdictional Accord and (ii)—swaps on broad-based groups or indices would be required to be traded on an approved board of trade, which in each case would render a privately negotiated transaction pertaining to such securities, groups of securities or indices, as the case may be, subject to challenge by the parties to the transaction as unenforceable. Such risks have led many participants to enter into such swap transactions on securities prices through off-shore affiliates.
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VIII .Legal Uncertainty Relating to Certain Foreign Currency Transactions
The Treasury amendment, which excludes certain foreign exchange transactions from the CEA, is statutory in nature and broader in scope than the Swaps Exemption. Therefore, unlike the Swaps Exemption, the Treasury amendment may not be revoked or modified by the CFTC and creates a statutory exclusion from the CEA for the transactions to which it applies.
Nevertheless, a tremendous amount of litigation has arisen with respect to the scope of the Treasury amendment. Without limiting its benefits to certain classes of participants, the Treasury amendment excludes from the scope of the CEA ''transactions in foreign currency . . . unless such transactions involve the sale thereof for future delivery conducted on a board of trade''. 7 U.S.C. —2, CEA —1(a)(3).
Ambiguity existed over the potential difference between transactions ''in'' foreign currency and transactions ''involving'' foreign currency, giving rise to potential legal concerns, but was settled in Dunn v. CFTC. 117 S. Ct. 913 (1997)
However, the meaning of the term ''board of trade'' continues to give rise to potential legal concerns. In Salomon Forex, Inc. v. Tauber, 8 F.3d 966, the United States Court of Appeals for the Fourth Circuit constructed the ''Treasury Amendment'' exempting transactions in foreign currency to reach beyond transactions in the commodity itself and to include all transactions in which foreign currency is the subject matter, including futures and options. Id. at 975. This reasoning was subsequently supported by the United States Supreme Court in Dunn. 117 S. Ct. 913 (1997).
IX. Legal Certainty Proposals
The unilateral actions taken by the CFTC in 1998 confirmed that the heart of the legal certainty problem is in the structure of the CEA itself. This means that the legal certainty issue can be clarified with the necessary finality only by Congress. There are several frameworks within which Congress could clarify that the CEA does not apply to swaps transactions. These range from a complete restructuring of the CEA to a more targeted and incremental approach to reform involving the clarification and expansion of exclusions. Both of these reform frameworks would readily accommodate broad regulatory relief for the organized futures exchanges as well as clarification of the legal certainty issues.
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Whatever CEA reform framework Congress chooses, there are four legal certainty issues that must be addressed. First, Congress should clarify that the CEA does not apply to swaps contracts and this clarification should extend to all forms of swaps contracts, including credit swaps and those based on securities prices, and not just to contracts described in the Treasury amendment. Similar statutory clarifications should be provided for so-called ''hybrid'' instruments that are predominantly securities or depository instruments.
Second, Congress the Treasury amendment should be retained and clarified in certain respects to assure continued legal certainty that the CEA does not apply to contracts in or involving Government securities, foreign currencies and the other contracts enumerated in the Treasury amendment. For example, the term ''board of trade'' should be replaced with a more precise concept such as ''organized futures exchange'' or ''designated contract market''. Congress should also clarify that contracts otherwise excluded from the CEA under either the Treasury amendment or the proposed exclusion for other swaps contracts will not become subject to the CEA merely because of the use of more prudent ''clearing'' and settlement arrangements.
Third, the CFTC's 1998 concept release on over-the-counter derivatives envisioned use by the CFTC of the exemptive authority granted by Congress as the basis for a broad range of regulatory burdens. To prevent a recurrence of such agency initiatives, Congress should take affirmative measures to assure that the statutory provisions it enacts to provide legal certainty that swaps and hybrid transactions are not subject to the CEA are not used by the CFTC to impose a broad range of non-legislative regulatory burdens on swaps transactions or on participants in those transactions. The imposition of such regulatory burdens is and should be a matter for Congressional decision and Congress should affirmatively preserve its prerogative to do so.
Fourth, while enactment of the ''legal certainty'' proposals outlined above will greatly reduce the deterrents to risk management and financial innovation that are inherent in the CEA, these changes are not in and of themselves sufficient. Specifically, Congress needs also to specify with reasonable precision whether there are any circumstances under which the use of electronic facilities will trigger CEA regulation of swaps transactions (or of participants in those transactions) that are otherwise excluded from the CEA under the proposals outlined above. Absent a definitive resolution of these issues, the obvious positive benefits of emerging technologies could well be offset by yet another round of legal and regulatory uncertainty that would in turn deter improvements in risk management techniques and other financial innovations. ISDA is prepared to work with the subcommittee to fashion an appropriate ''bright line'' resolution of these issues that will foster financial innovation in a manner responsive to appropriate public policy concerns.
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ISDA appreciates this opportunity to express its views regarding these important issues and would invite any further inquiries from the committee. If you should have any questions or comments, please feel free to contact any member of the ISDA Board of Directors listed in Annex A.
Testimony of Richard G. Ketchum
I am Richard G. Ketchum, president of the National Association of Securities Dealers. By way of introduction, prior to joining the NASD I was director of the Division of Market Regulation at the Securities and Exchange Commission. During my tenure at the Commission I was involved in the development of the Shad/Johnson Accord and all SEC/CFTC issues from 1977 to 1991. I was also privileged to be one of the SEC staffers who assisted the President's Working Group on Capital Markets while at the Commission.
I will limit my comments today to those aspects of the legislative proposal jointly developed by the Chicago Board of Trade and the Chicago Mercantile Exchange (the Joint Exchange Proposal) that could directly affect the securities markets: the repeal of the Shad/Johnson Accord and allowing securities salesmen to sell futures on securities so long as those futures enter the market through a futures commission merchant.
The Nasdaq Stock Market and the American Stock Exchange are members of the Ad Hoc Coalition on Intermarket Coordination and enthusiastically support the Coalition's strong opposition to lifting the ban on futures on individual stocks and narrow-based stock indices and support for excluding equity swaps from the Commodity Exchange Act and making clear that the Securities and Exchange Commission is authorized to exercise appropriate regulatory oversight of such products. We also opposed the Joint Exchange Proposal's suggestion that securities qualified sales person be permitted to sell futures on securities so long as those transaction are executed through a futures commission merchant.
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The NASD would like to thank the subcommittee for this opportunity to testify on reauthorization of the Commodity Futures Trading Commission. This is a timely topic. The financial landscape in this country is constantly changing and the velocity of that change is accelerating. I would like to take this opportunity to describe some of the activities that we conduct at the NASD and our wholly-own subsidiaries—the Nasdaq-Amex Market Group and NASD Regulation.
The NASD. Let me briefly outline the role of the NASD in the regulation and operation of our securities markets. Established under authority granted by the 1938 Maloney Act amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Virtually every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD's membership comprises 5,600 securities firms that operate in excess of 66,000 branch offices and employ more than 569,000 registered securities professionals.
The NASD is the parent company of The Nasdaq Stock Market, Inc., the American Stock Exchange, and NASD Regulation, Inc. (NASDR). These wholly-own subsidiaries operate under delegated authority from the parent, which retains overall responsibility for ensuring that the organization's statutory and self-regulatory functions and obligations are fulfilled. The NASD is governed by a 27-member Board of Governors, a majority of whom are non-securities industry affiliated. Board members are drawn from leaders of industry, academia, and the public. Among many other responsibilities, the Board, through a series of standing and select committees, monitor trends in the industry and promulgate rules, guidelines, and policies to protect investors and ensure market integrity.
The Nasdaq Stock Market. The Nasdaq Stock Market is the largest electronic, screen-based market in the world, capable of handling trading levels of at least one a half billion shares a day. Founded in 1971, Nasdaq today accounts for more than one-half of all equity shares traded in the Nation and is the second largest stock market in the world in terms of the dollar value of trading. It lists the securities of 5,100 domestic and foreign companies, more than all other U.S. stock markets combined.
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The American Stock Exchange. The American Stock Exchange is the nation's second largest floor-based securities exchange and is the only U.S. securities exchange that is both a primary market for listed equity securities as well as a market for equity options, index options, and equity derivatives. Amex has been the nation's foremost innovator in structured derivative securities and index share securities. The latter are registered investment companies that permit an indexed equity investment, as do index mutual funds, but afford investors the opportunity to purchase or sell on the Exchange at any time during the trading day. In addition, Amex's wholly owned subsidiary, Amex Commodities LLC was designated by the CFTC as a contract market in certain U.S. Treasury note futures in 1989. However, those contract market designations have not yet been utilized
NASD Regulation. NASD Regulation is responsible for the registration, education, testing, and examination of member firms and their employees. In addition, it oversees and regulates our members' market-making activities and trading practices in securities, including those that are listed on The Nasdaq Stock Market and those that are not listed on any exchange.
NASDR carries out its mandate from its Washington headquarters and 14 district offices located in major cities throughout the country. Through close cooperation with federal and state authorities and other self-regulators, overlap and duplication is minimized, freeing governmental resources to focus on other areas of securities regulation.
NASDR has examination responsibilities for all of its 5,600 members. In addition to special cause investigations that address customer complaints and terminations of brokers for regulatory reasons, NASDR conducts a comprehensive routine cycle examination program.
Chicago Futures Exchanges Proposed Repeal of Shad/Johnson. In general terms, the Shad/Johnson Accord prohibits the introduction and trading in this country of futures on industry sector/narrow-based stock indices and futures on individual stocks. It also provides for a carefully balanced system of review and cooperation by the SEC and CFTC in approving new products that straddle the line between securities and futures regulation.
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The Joint Exchange Proposal would effectively repeal that prohibition and limit the Securities and Exchange Commission's ability to review stock index futures contracts submitted to the CFTC. It would also empower the SEC to apply insider trading rules to nonexempt securities-based derivatives traded on a futures exchange to the same extent as it applies those rules to options traded on a national securities exchange.
Why Shad/Johnson Should Be Maintained. We are in the midst of rapid, defining changes in our financial markets. Changes that weren't even considered a few short months ago because the necessary technology didn't exist, are now being realized. The challenge and opportunity that these technological advances provide is how to implement them while maintaining the investor protections that are the fundamental building blocks of the integrity that our capital markets enjoy.
The Shad-Johnson Accord was adopted in 1982 in response to concerns about the application of conflicting regulatory approaches to closely-related securities and futures products. The Accord substituted a system of cooperation and joint review for a process that had been fragmented, contradictory, and resulted in frequent disputes between securities and futures regulators, which in some cases ended in federal court.
Shad-Johnson recognizes that there are significant differences between the regulatory schemes that apply to securities and to futures products. There is nothing inappropriate about those differences. Securities and futures in general carry very different risk characteristics, and the investor base of each is also quite distinct. Futures are traded overwhelmingly by institutions and some relatively sophisticated, wealthy individuals. The strength of our securities markets owes much to the widespread participation of many millions of retail investors, many of relatively modest means. Futures products are purchased by commercial interests to hedge market risk and in some cases by speculators, but in any event not for long-term investment.
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Because of the different characteristics of these products, many of the basic regulatory protections that apply to each are also very different.
The securities laws and rules of the self-regulatory organizations require that, when a firm recommends a transaction to a customer in a security, the firm must determine based on the facts it has gathered concerning the customer's financial situation, objective and needs, that the security is suitable for him or her. The same rules do not apply in the futures context. Futures regulation, in contrast, requires somewhat different account opening procedures in order to ensure, among other things, that customers understand the significant risks of trading in futures. As another example, the margin requirements set by the futures exchanges are significantly less than the requirements applicable to securities.
Further, different surveillance systems are in place for each of the two markets. Each securities and futures exchange maintains complex and costly systems for the moment-by-moment monitoring of trading in those markets to identify possible manipulations or other regulatory violations, and conduct investigations where that appears to be warranted. Differences in the regulatory structure of each market necessarily lead to differences in the design of these systems. For example, surveillance systems in the securities sphere generally are heavily used to look for potential examples of insider trading based on advance knowledge of information about an issuer. The insider trading concept as it is applied to securities trading does not have an analog in the futures markets. Other differences in the regulatory structure as described above would similarly affect the design of surveillance systems and the ways that surveillance is conducted.
Shad-Johnson permits the SEC and CFTC to each consider the regulatory implications of the trading of new products that are covered by the Accord, and to consider the ability of surveillance systems to identify possible violations. In some cases, trading in one market may be undertaken to manipulation or other illegal conduct in another. Securities and futures exchanges are members of the Intermarket Surveillance Group, which was set up to coordinate the sharing of information among securities and futures exchanges for surveillance purposes. This system has worked well, but regulators must still have a specific reason to suspect a violation and to ask for trading information from another market. Because of the absence of a single integrated surveillance system, the trading of derivative products that are closely related to the underlying instrument—for example, futures on individual securities—could be used to skirt rules that apply to securities trading. The existence of these dangers is one of the reasons that the role of each agency has been carefully preserved in the existing statute.
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The market break of October 1987 reinforced the importance of Shad-Johnson by demonstrating dramatically the interrelationship between equities and equity derivatives. This fact is undisputed. Because of the pricing relationship between futures and their underlying securities actions in one market directly affect the other. Following 1987, after considerable deliberation and experimentation, a number of measures such as circuit breakers, information sharing arrangements, and others to safeguard orderly markets were developed and implemented to protect the equity markets from systemic risk. To permit the trading of narrow-based and single stock futures would be ignoring the lessons learned since 1987.
Recent developments involving the popularity of on-line trading and day-trading and associated volatility underscore the importance of maintaining a system that recognizes the important relationships among markets and the ability of disruptions in one to be quickly translated to another.
Our desire is to ensure the maintenance of the integrity of our capital markets. This concern over the maintenance of the integrity of our capital markets is heightened by the fact that these markets serve as the investment vehicle or retirement savings choice of over 70 million Americans. This statistic attests to a basic observation, stocks are different from any other commodity on which futures contracts can be traded. A contributing factor to people's participation in the equity markets is their confidence in the markets' integrity and fairness. Anything that could potentially jeopardize that confidence is a cause of great concern to us. The United States is unique in the magnitude of public participation in our capital markets. These markets are the envy of the world. We should be extremely cautious when considering modifications that could affect these markets. Trading of futures on industry sector/narrow-based stock indices or futures on individual stock could affect the pricing of the stocks underlying those futures and increase stock market volatility.
NASD Response to Changing Market Situations. The concerns that were the foundation underlying the Shad/Johnson Accord are more relevant today that they were when the Accord was first enacted. An example of how the issue has become more complicated is the explosion on line trading and day trading. We have attempted to respond to some of these changes with two recent Notices to Members,
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Special Notice to Members 99-32 requests comment from members and other interested parties on proposed rules that would require a firm that has recommended a day-trading strategy to an individual to approve the individual's account for day trading. As part of the account approval process, the firm would be required to determine that the strategy is appropriate for the customer and provide a disclosure statement to the customer discussing the risks of day trading
Special Notice to Members 99-33 deals with another aspect of recent market conditions. During the past several months, many stocks, particularly those of companies that sell products or services on the Internet have experienced sharp increases in both volatility and trading volume. These extreme market conditions raise concerns regarding the use of margin accounts by individuals to trade volatile stocks. The notice provides information about current margin requirements and steps taken by the industry to increase maintenance margin requirements for certain volatile stocks. The Special Notice also solicits comment on issues relating to the use of margin during volatile market conditions, as well as the use of margin by individuals engaged in day-trading activities.
These Special Notices are merely the latest evidence of our steadfast commitment to the maintenance of market integrity and desire to adapt to changing market situations. The comment period on each of them expires at the end of this month.
The growth of on-line trading and day trading on-line are examples of how rapidly the dynamics of the markets are changing. The presence of such trading mechanisms elevates our concerns about their effect when potentially combined with futures on narrow-based indices and futures on individual stocks. The investor protection concerns we are addressing in our Special Notices are the same concerns that should arise if trading of futures on narrow-based stock indices and individual stocks is permitted.
Joint Exchange Proposal is Insufficient. In light of the regulatory and market surveillance differences discussed above, the Joint Exchange Proposal would expose the U.S. securities markets to unacceptable risks.
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While the Chicago exchanges are to be commended for including insider trading protections within their proposal, the inclusion of those protections while omitting others is incomplete and insufficient. The proposal does not attempt to address issues such as customer suitability and margin treatment. These are critical omissions.
Even if securities customer suitability and margin requirements, in addition to insider trading rules, are engrafted onto the regulatory regime for futures on industry sector/narrow-based stock index futures and individual equity futures, we believe that regime would still be deficient. We suggest that there needs to be an effective, integrated market surveillance system for both securities and futures before repeal of Shad/Johnson is seriously considered. Examinations must be part of integrated surveillance. This would be a minimum predictive/preventive step that could be taken. Such a system would facilitate detection of marking on the close and cross-market frontrunning and other market abuses. In the final analysis, we continue to believe that such products should properly be regulated as securities with all of the protections that such a regime provides since they could be used as securities surrogates.
This same reasoning raises serious concerns about the Joint Exchange Proposal's suggestion that securities qualified sales persons be permitted to sell futures on securities so long as those transactions are executed through a futures commission merchant. There is no basis for assuming that an individual who is qualified to sell securities is automatically qualified to sell futures on securities. Futures are a different class of products with their own characteristics. We are unaware of any justification for removing the necessity for a separate futures qualification examination for those who are to sell futures. The futures markets are institutional markets while the securities markets have significantly more retail participation. Both market models work well since they were designed and modified to address the realities of each market. Engrafting one model on the other would be ill-advised and could potentially result in significantly adverse consequences. The creation of a new class of retail consumer products, which appears to be the objective of the proponents of Shad/Johnson repeal, would result in products of a totally different character than the current futures offerings.
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Our equity markets are the envy of the world. Anything that could even remotely jeopardize or discredit them should be approached with extreme caution. We continue to believe that unless narrow-based stock index futures and futures on individual equities are subject to the full panoply of securities regulatory requirements, that is regulated as securities, they should not be permitted.
Securities and Exchange Chairman Arthur Levitt in a May 4 address before the National Press Club stated that: ''We are living in a time when the stock market is more a part of the American consciousness than ever before. After years of nothing but up markets and empowering technology, the investor psyche has gone through a lot of changes. Memories have shortened and important points may have gotten lost in the excitement.'' We wholeheartedly agree with Chairman Levitt's observations. We further believe that although his comments were directed to on-line trading of securities they are equally applicable to the potential trading of futures on individual stocks and narrow-based stock indices. Caution should be the watchword in approaching initiatives to allow the trading of those products. Stocks are different from futures and futures on individual stocks and narrow-based stock indices are different from other futures.
We thank the subcommittee for its attention to this important issue. We stand ready to work with you and your staff as you continue your deliberations on the CFTC reauthorization legislation.
Testimony of Jane Carlin
I am Jane Carlin, a managing director at Morgan Stanley Dean Witter. I am appearing before the subcommittee today in my role as chairwoman of the Over-the-Counter Derivative Products Committee of the Securities Industry Association. On behalf of the SIA, I want to express my appreciation for this opportunity to present the securities industry's views on the very important matter of the reauthorization of the Commodity Futures Trading Commission and issues arising under the Commodity Exchange Act SIA is the primary trade association representing the U.S. securities industry. SIA brings together the shared interests of more than 740 securities firms. SIA member firms (including investment banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all phases of corporate and public finance. The U.S. securities industry manages the accounts of more than 50 million investors directly and tens of millions of investors indirectly through corporate, thrift and pension plans. The industry generates more than $300 billion of revenues yearly in the U.S. economy and employs more than 600,000 individuals. (More information about the SIA is available on our home page at http://www.sia.com).
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With the rapid evolution and expansion of OTC derivatives and hybrid products over the last two decades, the issues involved in the reauthorization of the CFTC are now very important to SIA members and our customers. SIA is pleased that the current reauthorization process allows Congress the opportunity to reexamine the CEA in light of the changes that have characterized the financial markets during the last decade. As evidenced by our participation here today, SIA hopes to be actively involved with the Congress in shaping a modern and reinvigorated CEA that is responsive to the need for legal certainty for OTC derivatives and hybrid products as we enter the next century. My comments today will focus primarily on issues in the CEA that relate to securities and securities dealers.
While later in my testimony I will provide specific recommendations for the subcommittee to consider, the SIA's chief concerns can be summarized as follows:
Over-the-counter derivatives and hybrid instruments have been a singular U.S. financial success story. OTC derivatives and hybrid instruments perform vital functions for corporations in all sectors of the economy. They facilitate risk management and investment opportunity. Congress has played an important role in contributing to these positive developments. Congress must take further steps at this time to ensure that the CEA does not stand as an obstacle to further progress in these areas.
The uncertain legal status of OTC derivatives and hybrids and the barriers to innovation inherent in current law present unacceptable problems for market participants that must be redressed by statutory revisions to the CEA. Clear and objective statutory exclusions for these OTC products must be codified to clarify the status of existing products and to reduce the risk of future uncertainty as new products are introduced.
Legal uncertainty is particularly acute in the context of OTC derivatives and hybrids based on non-exempt securities. These products should be expressly excluded from the CEA.
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The CEA currently poses a significant obstacle to product and technological innovations concerning the execution, clearing and settlement of OTC derivatives and hybrid products, such as electronic trading, that could lower the cost of risk management, promote liquidity and reduce systemic risk.
Although reauthorization involves many complex problems without clear answers, one thing is certain: the solution is not to preserve the current state of legal uncertainty and intolerable barriers to innovation.
I. The CEA Must Reflect the Modern Competitive Global Market.
Looking back over the evolution of the CEA and its predecessors, Congressional policy has historically focused on the U.S. domestic market and primarily on exchange-based trading of physical commodities. However well that approach may have served the interests of the agricultural sector, that approach will not work for international financial markets. Globalization has led to worldwide competition in virtually every aspect of the financial services industry. Electronic trading has taken hold as a dominant force and international over-the-counter markets have proliferated to meet customer demand. The U.S. cannot afford the luxury of dealing with the CEA and affected domestic institutions in a parochial or protectionist manner as if isolated from the competitive realities of world markets.
The U.S. financial industry is the world leader and SIA's members are fiercely committed to continue to hold that premier place on the global stage. While SIA member firms are obliged daily to manage and mitigate a wide range of risks arising from their activities, the one risk that these firms cannot effectively manage is legal risk, including that arising from the CEA as it currently is written. To the extent that conducting business with U.S. financial institutions introduces such legal risk into a transaction that does not arise when doing business with European or Asian dealers, U.S. dealers face a substantial competitive disadvantage. Forcing U.S. financial institutions offshore to avoid legal risk deprives U.S. customers of the financial products they need to compete both domestically and internationally.
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Moreover, moving global financial centers offshore seriously diminishes the United States' standing in the global financial markets and reduces America's influence on matters affecting international financial and monetary policy. None of these outcomes is in the best interests of the United States. These threats should be of grave concern to the subcommittee. In our view, the challenge before Congress now is to remove these legal uncertainties and to eliminate the related barriers to innovation for all market participants, thereby creating incentives for U.S. financial institutions to continue at the vanguard of global market innovation while remaining based here in the U.S.
While these products and issues may seem esoteric and obscure—and, indeed, they are—the subcommittee must not underestimate their economic significance.
II. OTC Derivatives and Hybrids
History. The development of OTC derivatives Derivatives are contracts that have a market value determined by the value of a stock, bond, commodity, interest rate, foreign currency or index (called the *underlying*). Derivatives typically include forwards, futures, options, and swaps contracts.
and hybrid instruments Generally, a hybrid is a financial instrument which combines the features of a debt instrument and a derivative and which links some portion of its return to changes in a particular commodity price, foreign exchange rate, interest rate, security price or index.
represents one of the great financial success stories of this century. Changes in the global financial architecture in the 1970's subjected all corporations to significant volatility in interest rates, foreign exchange rates and commodity prices. The commodity futures market responded with new financial futures contracts—in addition to their more traditional agriculture contracts. The financial markets also responded to these new risk management needs by offering custom tailored derivatives that were specifically designed to enable individual firms to manage their specific risks.
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OTC derivatives—primarily swaps and hybrids—are powerful tools which enable businesses to unbundle and transfer risks, including by hedging, to other entities willing and able to accept them. They are extremely flexible and can be customized to address unique risk management needs and to meet new challenges presented by a rapidly evolving global economy.
Legal Uncertainty. As exchange trading of financial futures contracts grew, Congress recognized that the nature of the futures markets was changing. In order to modernize oversight of these markets, Congress enacted the Commodity Futures Trading Act of 1974. The new statute dramatically expanded the basic definition of a ''commodity '' to include, in addition to the traditional enumerated list of agricultural commodities, ''. . . all other goods and articles, . . . and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in . . . . The intent of this definitional expansion was to clarify that the CEA applied to the new physical and financial futures contracts that were then being traded alongside traditional commodity futures on the exchanges. However, because of the potentially broad scope of the term ''futures contract,'' confusion regarding the CEA's applicability to OTC swaps—and later hybrids—subjected these instruments to the risk of contract repudiation and allegations of illegality if they arguably violated the act's strict off-exchange trading prohibition.
CFTC and Congressional Responses. The increasing importance of OTC derivatives and hybrids led to increased regulatory interest by the CFTC. The CFTC recognized the problem of the legal uncertainty associated with swaps and responded in 1989 by issuing the Swaps Policy Statement. 54 Fed. Reg. 30694 (July 21, 1989).
In effect, the policy statement created a regulatory safe harbor for qualifying swaps transactions by identifying those transactions which the CFTC would not take action to preclude or regulate as futures under the CEA.
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The CFTC responded similarly to the problem of the legal uncertainty threatening hybrid instruments by issuing the Hybrid Statutory Interpretation. The CFTC originally published the Statutory interpretation in January, 1989, 54 Fed. Reg. 1139 (Jan. 11, 1989). Following further comments it had solicited, the CFTC subsequently published a revised Statutory Interpretation in April, 1990. 55 Fed. Reg. 13582 (Apr. 11, 1990).
In the Statutory Interpretation, the CFTC indicated that it would not assert regulatory jurisdiction over certain categories of hybrid instruments.
While the Policy Statement and the Statutory Interpretation provided some degree of assurance that the CFTC would not take enforcement action against certain swaps and hybrids, it did not eliminate the legal risk that a counterparty might challenge the transaction or instrument in court.
Congress recognized the benefits of OTC derivatives and hybrid products and sought to encourage their development through the CEA by enacting the Futures Trading Practices Act of 1992 (FTPA). Pub. L. No. 102-546, 106 Stat. 3590 (1992).
The FTPA for the first time vested the CFTC with the authority to grant broad exemptions from the provisions of the CEA other than from the requirements of the Shad-Johnson Accord (discussed below). In order to provide certainty and stability to the markets, Congress also directed the CFTC to create an exemption for swap transactions and hybrid instruments. In doing so, Congress demonstrated an appreciation that the public policy concerns which motivated the CEA are not raised by OTC derivatives.
Rationale for the Swaps and Hybrid Exemptions. The CEA and its predecessor statutes were enacted for a simple purpose: to require that futures contracts on agricultural commodities be traded on licensed boards of trade that had implemented adequate protections against price manipulation. Commodity futures contracts, by virtue of their standardization and physical delivery terms, were perceived to be susceptible to manipulation. Congress was concerned that manipulation of the futures markets in turn caused distortions in the prices for agricultural commodities, because the futures markets are the primary price discovery mechanism for these products.
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By their nature OTC derivatives transactions do not present price discovery and manipulation concerns of the kind presented by standardized contracts requiring physical delivery.
Likewise, the principal regulatory challenge presented by hybrid instruments is not to prevent commodity price manipulation but, as is the case with more traditional securities, to ensure the adequacy of disclosure regarding the economic performance of and risks associated with the investment. The CEA was designed to protect markets against price manipulation and fraud, not to facilitate disclosure of material information to the capital markets. By contrast, disclosure is at the heart of the Federal securities laws. Moreover, hybrid instruments, as with swaps, do not serve as the mechanism for discovering the price of the underlying, and thus do not present the same price manipulation concerns as do commodity futures.
Swaps and Hybrid Exemptions. Following the FTPA's Congressional mandate, the CFTC issued final rules in 1993 exempting certain qualifying OTC swaps agreements and hybrid instruments from regulation under the CEA. CFTC Regulations Part 34 (Hybrid Exemption), and CFTC Regulations Part 35 (Swap Exemption).
While the swap and hybrid exemptions were helpful insofar as they provided needed practical relief to the markets, they were designed to reflect the way swaps and hybrids were transacted and designed at the time. SIA now believes the exemptions are too inflexible to appropriately accommodate innovative developments in the rapidly evolving financial marketplace and the global economy. Statements made by the CFTC over the past year have also raised concerns regarding the scope of and true protection afforded by these exemptions.
Barriers to Innovation. In its current form, the CEA impedes the development of new products designed to address changing risk management needs. Financial institutions must be free to respond to market changes and end user demands with innovative products—without having to confront costly and time-consuming and often insurmountable statutory and regulatory obstacles.
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The CEA and its regulations also have hampered innovations associated with the trading, clearing and settlement of products. For instance, while clearing of swaps transactions would have the beneficial effect of mutualizing and reducing counterparty default risks, the swap exemption does not allow clearing of OTC swaps, unless a specific exemption is granted. These restrictions therefore can have the ironic result of actually increasing default risks in OTC swap transactions and, in turn systemic risks. There seems to be no public policy reason to limit the ability of the financial system to clear and settle transactions. Indeed, public policy should encourage development of clearing mechanisms wherever possible to reduce risk in the financial system.
The CFTC also has taken the view that the use of certain electronic trading mechanisms to execute OTC derivatives transactions implicates the agency's exclusive jurisdiction under the
CEA. An enormous variety of electronic trading mechanisms—ranging from relatively simple to extraordinarily complex—are used throughout the financial system and around the world. One feature electronic trading systems generally have in common, however, is that they make trading more efficient, reduce costs and equalize market access. They also can offer benefits to the markets in terms of increased liquidity and price transparency. Unfortunately, the threat that simply using an electronic trading system might suddenly convert an otherwise exempt swap into a product which may be subject to CEA regulation has stifled useful and desirable electronic trading innovations here in the U.S.—at the same time as electronic trading systems proliferate overseas. This situation again puts U.S. financial institutions at a competitive disadvantage.
The Current Situation Demands Congressional Action. The CFTC exacerbated the situation last year when it issued its Concept Release. 63 Fed.Reg. 26114 at 26122 (May 12, 1998).
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By implying that swaps and hybrid instruments could be futures, the CFTC has cast additional doubt on their legal status. The result is a regulatory climate that subjects both newly developed and well-established products to legal uncertainty. No other class of financial instruments confronts this legal risk. This situation jeopardizes the availability and increases the cost of important risk management tools to companies throughout the U.S. economy. It also creates incentives for U.S. firms to conduct their transactions offshore beyond the jurisdictional reach of the CEA. Importantly, this threat reduces the leadership position of the U.S. financial sector in financial innovation and reduces the U.S. influence in world financial markets.
The history of the CEA evidences a repeated and counter-productive cycle wherein legal uncertainty arises and Congress eventually responds to individual issues, but not in a way which resolves the core structural problem with the CEA itself. There is something materially wrong with a regulatory scheme that continually and repeatedly jeopardizes otherwise lawful and socially desirable economic activity. Congress should restore the legal certainty that it intended to create both in 1974 and 1992 by enacting clear statutory exclusions for swaps and hybrids. These exclusions should be sufficiently flexible to accommodate innovations both in OTC products themselves and the manner in which the OTC business is conducted.
Recommendations:
Congress should specifically exclude swaps and hybrid instruments from the CEA.
Congress should provide flexibility in this exclusion to allow the evolution of new products.
Congress should clarify that clearing or electronic trading of swaps and hybrids do not subject the transactions or products to regulation under the CEA.
III. Swaps and Hybrids Based on Non-exempt Securities
OTC contracts based on or involving non-exempt debt or equity securities (also known as equity swaps or equity hybrids) allow parties to transfer the risk associated with changes in the price of an underlying security, basket of securities or securities index, without actually transferring ownership of the securities themselves. These products allow institutional investors and portfolio managers to hedge the risks associated with increasingly volatile securities markets. They provide means for institutional investors and portfolio managers to invest in new and emerging financial markets. They enable corporations to hedge the risks associated with direct investment in foreign markets. They allow firms to diversify their exposures to credit risk and, therefore, provide an important systemic risk management function. They enable corporations to reduce the cost of stock buybacks and employee stock option programs. They permit entrepreneurs to preserve assets by diversifying the risks associated with concentrating their wealth in a large block of a single stock. But many market participants have sought to enter into these types of transactions in jurisdictions outside the U.S., where their regulatory treatment is not subject to doubt.
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Swaps and hybrids based on non-exempt debt and equity securities are subject to an even greater degree of legal uncertainty than other swap and hybrid transactions. The legal uncertainty surrounding these particular OTC products stems from a 1981 jurisdictional agreement, known as the Shad-Johnson Accord, between the CFTC and the SEC over transactions involving securities. Congress incorporated the Accord into the CEA in 1983. The Futures Trading Act of 1982. Pub. L. No. 97-444, tit. I, 96 Stat. 2294 (1983). Codified at CEA 2(a)(1)(B).
One provision of this agreement prohibits the CFTC from exempting contracts on non-exempt securities from regulation under the CEA. The effect of this legal uncertainty is that it increases the risks to parties engaging in such transactions, and encourages firms to execute such transactions outside the U.S. to the extent possible.
In this area, the CEA again serves to impede innovation in the marketplace, and drive valuable business outside the U.S. If there is one issue that SIA would have this subcommittee address, it would be to correct this situation. No business should be subject to the risk that billions of dollars of legitimate contracts can be called into question by any regulator or by a judge. The systemic risk implications are obvious, and the current situation is not tolerable. This committee understood the need to take urgent, interim action last year to prevent damage to a marketplace, action for which we are very grateful. SIA now asks Congress to address the problem permanently.
Recommendation:
Congress should amend the CEA to explicitly exclude swaps and hybrid instruments based on non-exempt securities.
IV. Congress Must Bring Legal Certainty to the CEA's ''Treasury amendment.''
The term ''Treasury amendment'' refers to an amendment to the CEA proposed by the Treasury Department in 1974, which specifically excluded various financial instruments—including transactions in OTC derivatives involving Government securities and foreign exchange—from regulation under the CEA. The Treasury Amendment provides that
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Nothing in [the CEA] shall be deemed to govern or in any way be applicable to transactions in foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase options, government securities, or mortgages and mortgage purchase commitments, unless such transactions involve the sale thereof for future delivery conducted on a board of trade with statutory citation.
CEA 2(a)(1)(A(ii).
The Government securities and foreign exchange markets were then and continue to be the deepest, most liquid and most important financial markets in the world. These were and are off-exchange, inter-bank and inter-dealer markets which served a predominantly institutional and sophisticated client base. Congress agreed with the Treasury Department that the foreign currency and Government securities markets did not present the concerns presented by the exchange-traded futures markets. In addition, Congress recognized that vibrant Government securities and foreign exchange markets were vital to the national interest, and that potential application of the regulatory constraints of the CEA to these markets would be unnecessary and inappropriate.
The Treasury amendment excludes transactions in Government securities and foreign exchange from regulation under the CEA unless they are ''conducted on a board of trade.'' In 1997, the Supreme Court ruled that the Treasury Amendment excluded from the CEA any transaction in which foreign currency is involved unless conducted on a *board of trade*. Dunn v. CFTC, 519 U.S. 465 (1997).
While virtually every clause of the Treasury amendment has been litigated, the phrase ''board of trade'' has been particularly problematic. Although standard usage and the legislative history suggest that Congress intended the term ''board of trade'' to mean ''organized exchange,'' broad interpretations by the CFTC and some courts have subsequently caused a great deal of confusion over the meaning of the term. For example, in CFTC v. Standard Forex, Inc., 1993 U.S. Dist. LEXIS 19909 (EDNY 1993), the district court determined that *board of trade* included sales of foreign currency futures to the general public by firms not otherwise regulated by a federal agency.
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The Ninth Circuit recently held in CFTC v. Frankwell Bullion Ltd., 99 F.3d 299 (9th Cir., 1996)
that the term ''board of trade'' in the Treasury amendment means an ''organized exchange,'' and that all off-exchange transactions were exempt. Similarly, the district court in Kwiatkowski v. Bear Stearns & Co., Inc. 1997 U.S. Dist. LEXIS 13078 (SDNY 1997).
held that principal-to-principal, privately negotiated agreements for OTC purchases or sales of foreign currency were not conduced on a ''board of trade'' within the meaning of the Treasury amendment.
More recently, the CFTC and others have suggested that electronic trading systems could be considered boards of trade for purposes of the Treasury amendment. As a result, products that would otherwise be covered by the Treasury amendment could be subject to CEA regulation merely because the parties transact their business through a computer system rather than over the telephone. As discussed above, electronic trading systems can vary widely in their characteristics, and it would be wholly inappropriate to subject every one to regulation or to CEA-style regulation. Electronic trading is widespread in the Government securities market, and CFTC oversight of this market would clearly be inappropriate. The CFTC has also suggested that clearing of contracts may give rise to a board of trade, which as suggested above discourages the development of mechanisms that reduce systemic risk. The practical consequence of these CFTC positions is to deny services to U.S. businesses, because market participants are wary of operations that could cause them to be covered by the CEA.
Beyond the controversy over the meaning of the phrase ''board of trade,'' the CFTC has also taken the position that the Treasury amendment exclusion is limited to ''sophisticated and informed institutions'' and does not apply to transactions involving the general public, whether or not such transactions are conducted on an organized exchange. The CFTC has advocated this position notwithstanding the holding in the Frankwell Bullion case and the opposing view of the Treasury Department. Nonetheless, the potential application of the CEA has created potential legal uncertainty for OTC derivatives involving Government securities.
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Furthermore, the list of products excluded by the Treasury amendment has not been amended since it was enacted. Changes are necessary to clarify that certain other appropriate products are included, such as Government agency securities and securities issued by foreign governments.
Recommendations:
Congress should clarify that the term ''board of trade'' means ''organized exchange.''
Congress should clarify that all transactions in products covered by the Treasury amendment are excluded from the CEA.
Congress should update the list of specific products excluded from the CEA under the Treasury amendment.
Congress should clarify that electronic trading systems do not constitute a ''board of trade'' for purposes of the CEA.
Congress should clarify that the clearing of Treasury amendment products does not mean that those transactions are ''conducted on a board of trade'' for purposes of the CEA.
OTC Derivatives Dealers Do Not Need Duplicative Regulation by the CFTC.
The CFTC has suggested in the Concept Release and in public statements See, e.g., testimony of Brooksley Born, Chairperson, CFTC, before the U.S. House of Representatives Banking and Financial Services Committee, July 24, 1998.
(as have others) that OTC derivatives dealers should be subject to regulation under the CEA. SIA disagrees with the basic premise that OTC derivatives dealers require regulation. SIA further believes that even if public policy warranted such regulation, the CEA would clearly not be the appropriate statutory authority. First, well over 90 percent of the volume of OTC derivatives transactions are conducted with dealers who are regulated either as banks by the Federal and state banking regulators, or as affiliates of broker-dealers that are subject to risk assessment requirements under the securities laws and internal control and reporting obligations under the Derivatives Policy Group voluntary oversight framework. Many of these firms must also comply with regulations of the Treasury Department. No case has been made that there is a need for additional regulation in this area. To add another layer of entity-level regulation would be unnecessary, duplicative and wasteful for both the dealers and U.S. taxpayers.
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SIA also fundamentally disagrees that CEA regulation would be appropriate for dealers in derivatives if such regulation was deemed to be advisable. As discussed above, the CEA's regulatory design, while appropriate to organized exchanges, is ill-suited to oversee off-exchange products, markets, and entities. The issues posed in the regulation of derivatives dealers bear no resemblance to the issues addressed by CEA regulation. The CFTC has little or no experience with issues faced on a daily basis by derivatives dealers, and developing sufficient expertise would be a major distraction from the CFTC's primary mission: regulating and safeguarding the nation's commodity markets.
Recommendation:
Congress should not subject OTC derivatives dealers to regulation under the CEA.
VI. Conclusion
SIA believes this committee must address these long overdue reforms of the CEA. We understand it is a complex and time consuming task and we applaud your willingness to undertake this effort. SIA believes that providing the U.S. financial markets with the flexibility to innovate is worth the effort to reform the CEA.
Mr. Chairman, as you know, these are not just issues involving the futures exchanges. The CEA presents unacceptable systemic risks to the financial markets that must be addressed. Statutes should be designed to reduce risk to society. Instead, the CEA creates risks and limits the availability of tools and market mechanisms to manage risk. This subcommittee should not tolerate these risks. We strongly believe that the time has come to resolve issues which are over 20 years old. The global markets and international firms will not stand still while we sort out our anachronistic regulatory problems.
SIA is not prepared to insist that Congress vastly alter the current structure of the CEA to accommodate the concerns of the financial markets. However, the CEA simply does not work in the context of the OTC markets and is a barrier to progress. Therefore, we respectfully request that Congress provide clarification on the various issues discussed herein, so that the CEA does not continue to cloud our markets with uncertainty and impede innovation.
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Testimony of Kenneth M. Raisler
On behalf of the entities listed in the attached Appendix (collectively, the Energy Group), I am pleased to submit this written testimony regarding the Commodity Futures Trading Commission's reauthorization. I am a partner in the law firm of Sullivan & Cromwell which is serving as counsel to the Energy Group. The members of the Energy Group consist of oil and gas producers, refiners, processors and marketers, as well as electric utilities and marketers of electricity. Members of the Energy Group are active participants in the principal domestic and international physical, futures and over-the-counter derivatives markets for energy products including oil, natural gas and electricity. We appreciate the invitation to express our views. This testimony focuses on those issues of major concern to a broad range of energy companies.
Before I discuss those issues, I would like to point out that many members of the Energy Group have been active participants in CFTC reauthorizations and exemptive actions for over a decade. Energy Group members were actively involved during the 1989–92 period leading up to the CFTC's reauthorization in 1992. We were strong supporters of granting the Commission exemptive authority. Following reauthorization, we applied to the CFTC for an exemption for certain contracts involving energy products which was granted by the CFTC in April 1993. This exemption provided legal certainty for a large category of energy contracts critical to the risk management and other business needs of the energy industry. More recently, in June 1998, the Energy Group wrote to this committee supporting legislation proposing a moratorium on any CFTC rulemaking in the derivatives area and expressing our serious concern with the CFTC's Concept Release on Over-the-Counter Derivatives.
The issue of legal certainty with respect to OTC derivatives involving energy products remains of paramount concern. In addition, we are opposed to the recent suggestion that derivatives dealers, including derivatives dealers in energy contracts, should be regulated. Furthermore, we seek clarity with respect to the regulatory treatment of a variety of electronic trading systems for energy products so that such systems may be offered in the United States without the burdens of CFTC regulation.
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Legal Certainty. The CFTC's 1998 Concept Release on Over-the-Counter Derivatives (Concept Release) suggested that the exemptions that the CFTC adopted in 1992 and 1993 should be revised. These exemptions provide important legal certainty to the market and any changes that would limit the scope of these exemptions would create legal uncertainty about the enforceability of OTC derivatives transactions. Changes that could encourage OTC derivatives participants to attempt to walk away from their transactions claiming that they were illegal, off-exchange futures contracts would impose new costs and risks to market users and ultimately undermine the value of these important risk management products.
The Concept Release also represented an attempt by the CFTC to propose a comprehensive regulatory scheme for OTC derivatives. Such a scheme, if adopted, would create new uncertainties and would severely disrupt a broad range of trading and risk management activities. Many providers of risk management tools, such as swaps and hybrid instruments, faced with the increased costs and burdens of regulation would withdraw from the domestic market or severely limit the products they are willing to offer. As a result, farmers, energy producers and consumers, and other users of derivative products would be required to pay more for necessary risk management products or would be unable to use those tools to control their exposure to energy and commodity prices.
With the ongoing and expanding deregulation of the energy industry at the Federal and state levels, including, most recently, electricity, there is a growing, essential need for derivatives to manage these new risks. The companies comprising the Energy Group use derivatives as an essential part of their every day business and also provide hedging services to their customers either on a stand-alone basis or as part of the marketing of energy products. The importance of derivatives for the Energy Group companies and their customers cannot be overestimated. Unlike other dealers and users of derivative products, many commercial producers and users of energy, including utilities, refineries and marketers, cannot effectively relocate offshore. The success of this business can be completely undermined by new legal uncertainties or a costly regulatory regime that adds no value to the energy industry.
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The primary goal of the CFTC reauthorization process should be to provide legal certainty to the OTC derivatives markets. Codification of existing exemptions and clear direction to the CFTC is necessary to avoid the disruptive effects of new initiatives along the lines of the Concept Release or the implementation of a rulemaking that follows any of the proposals in the Concept Release.
Derivatives Dealers Should Not Be Regulated. Since 1993 when members of an earlier constituted Energy Group testified before a subcommittee of the House Committee on Agriculture, we have been on record strongly supporting the benefits of an energy derivatives dealer community that is not regulated by the CFTC. Since that time, there has been very substantial growth in the development and sale of energy derivatives. This enormous growth has occurred without incident or complaint. There is absolutely no evidence to support the need for or the benefits of CFTC regulation of energy derivatives dealers. The overwhelming majority of OTC derivatives dealers and users are commercial entities in the trading or energy business. The purchasers of OTC energy derivatives know how to protect themselves. They have full recourse to an existing body of commercial contract laws and state and common laws as the basis to litigate any dispute that they may have with their dealers. There is no basis to support any CFTC involvement in or regulation of this dealer community. Regulation of derivatives dealers would only serve to increase costs and reduce the number of dealers willing to provide services in these markets. This would reduce the efficiency and liquidity of energy markets to the detriment of all energy producers and consumers.
Electronic Trading Systems. Over the last several years a number of electronic trading systems for energy products have been developed and offered outside of the United States. These innovative and efficient systems for the trading of energy products should be permitted in the United States without the risk that they may violate the Commodity Exchange Act. Although the systems do not operate, and need not be regulated, as exchanges, at the present time the Commodity Exchange Act and interpretations of the CFTC raise questions about what is an exchange and whether some of these electronic trading systems might be required to be regulated by the CFTC as exchanges. Greater legal certainty in this area is essential for the growth and viability of these services. Clarification from the CFTC and, more effectively, legislation from Congress is necessary to promote electronic trading systems in the United States.
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Electronic trading systems for energy products represent a natural evolution in the trading business taking advantage of new technologies to promote trading efficiency and liquidity. Systems that allow participants to post bids and offers and execute transactions electronically against each other is the logical next step to replace the same services performed by telephone brokers. As with the issue of energy derivatives dealer regulation, the participants in these electronic trading systems are sophisticated producers, consumers and merchandisers of energy products who do not need and will not benefit from CFTC regulation.
I11I appreciate the opportunity to present this testimony. Should the committee have any questions, I will be pleased to respond on behalf of the Energy Group.
BP America, Inc., Enron Capital & Trade Resources Corp., J. Aron & Company, Koch Industries, Inc., Mobil Business Resources Corporation, Phibro Inc., Sempra Energy Trading Corp.
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