SPEAKERS CONTENTS INSERTS
Page 1 TOP OF DOC65306 CC
THE COMMODITY FUTURES MODERNIZATION ACT OF 2000
SUBCOMMITTEE ON RISK MANAGEMENT,
RESEARCH, AND SPECIALTY CROPS
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
JUNE 14, 2000
Page 2 PREV PAGE TOP OF DOCSerial No. 10654
Printed for the use of the Committee on Agriculture
COMMITTEE ON AGRICULTURE
LARRY COMBEST, Texas, Chairman
BILL BARRETT, Nebraska,
JOHN A. BOEHNER, Ohio
THOMAS W. EWING, Illinois
BOB GOODLATTE, Virginia
RICHARD W. POMBO, California
CHARLES T. CANADY, Florida
NICK SMITH, Michigan
TERRY EVERETT, Alabama
FRANK D. LUCAS, Oklahoma
HELEN CHENOWETH-HAGE, Idaho
JOHN N. HOSTETTLER, Indiana
SAXBY CHAMBLISS, Georgia
RAY LaHOOD, Illinois
JERRY MORAN, Kansas
BOB SCHAFFER, Colorado
JOHN R. THUNE, South Dakota
Page 3 PREV PAGE TOP OF DOCWILLIAM L. JENKINS, Tennessee
JOHN COOKSEY, Louisiana
KEN CALVERT, California
GIL GUTKNECHT, Minnesota
BOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
CHARLES W. STENHOLM, Texas,
Ranking Minority Member
GARY A. CONDIT, California
COLLIN C. PETERSON, Minnesota
CALVIN M. DOOLEY, California
EVA M. CLAYTON, North Carolina
DAVID MINGE, Minnesota
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
TIM HOLDEN, Pennsylvania
SANFORD D. BISHOP, Jr., Georgia
BENNIE G. THOMPSON, Mississippi
JOHN ELIAS BALDACCI, Maine
MARION BERRY, Arkansas
Page 4 PREV PAGE TOP OF DOCMIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
BOB ETHERIDGE, North Carolina
CHRISTOPHER JOHN, Louisiana
LEONARD L. BOSWELL, Iowa
DAVID D. PHELPS, Illinois
KEN LUCAS, Kentucky
MIKE THOMPSON, California
BARON P. HILL, Indiana
JOE BACA, California
WILLIAM E. O'CONNER, JR., Staff Director
LANCE KOTSCHWAR, Chief Counsel
STEPHEN HATERIUS, Minority Staff Director
KEITH WILLIAMS, Communications Director
Subcommittee on Risk Management, Research, and Specialty Crops
THOMAS W. EWING, Illinois, Chairman
BILL BARRETT, Nebraska,
NICK SMITH, Michigan
TERRY EVERETT, Alabama
Page 5 PREV PAGE TOP OF DOCFRANK D. LUCAS, Oklahoma
SAXBY CHAMBLISS, Georgia
RAY LaHOOD, Illinois
JERRY MORAN, Kansas
JOHN R. THUNE, South Dakota
WILLIAM L. JENKINS, Tennessee
GIL GUTKNECHT, Minnesota
BOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
GARY A. CONDIT, California,
Ranking Minority Member
CALVIN M. DOOLEY, California
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
SANFORD D. BISHOP, Jr., Georgia
JOHN ELIAS BALDACCI, Maine
MIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
BOB ETHERIDGE, North Carolina
CHRISTOPHER JOHN, Louisiana
Page 6 PREV PAGE TOP OF DOCLEONARD L. BOSWELL, Iowa
KEN LUCAS, Kentucky
MIKE THOMPSON, California
JOE BACA, California
C O N T E N T S
Barrett, Hon. Bill, a Representative in Congress from the State of Nebraska, prepared statement
Bishop, Hon. Sanford D., Jr., a Representative in Congress from the State of Georgia, prepared statement
Ewing, Hon. Thomas W., a Representative in Congress from the State of Illinois, opening statement
Stabenow, Hon. Debbie, a Representative in Congress from the State of Michigan, prepared statement
Stenholm, Hon. Charles W., a Representative in Congress from the State of Texas, opening statement
Nazareth, Annette L., Director, Division of Market Regulation, Securities and Exchange Commission
Answers to submitted questions
Parkinson, Patrick M., Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System
Page 7 PREV PAGE TOP OF DOCPrepared statement
Answers to submitted questions
Paul, C. Robert, General Counsel, Commodity Futures Trading Commission
Sachs, Lewis A., Assistant Secretary, Financial Markets, U.S. Department of the Treasury
Answers to submitted questions
Bond Market Association, statement
Brennan, David, chairman of the board, Chicago Board of Trade, statement
Chicago Mercantile Exchange, statement
Damgard, John M., president, Futures Industry Association, statement
Erickson, Thomas J., Commissioner, Commodity Futures Trading Commission, statement
Frankland, Walter L., Jr., executive vice-president, Silver Users Association, statement
Kloet, Thomas A., chief executive officer, Singapore Exchange, statement
Massa, Jose, chief executive officer, Spanish Financial Futures and Options Exchange, statement
Raisler, Kenneth M., on behalf of the Energy Group, statement
Securities Industry Association, statement
Theodore, Jean-Francois, chairman, Euronext, statement
Williamson, Brian, chairman, the London International Financial Futures and Options Exchange, statement
Page 8 PREV PAGE TOP OF DOC U.S. Securities Markets Coaliton, statement
THE COMMODITY FUTURES MODERNIZATION ACT OF 2000
WEDNESDAY, JUNE 14, 2000
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
The subcommittee met, pursuant to call, at 10:20 a.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Barrett, Smith, Everett, Lucas of Oklahoma, LaHood, Moran, Thune, Jenkins, Gutknecht, Riley, Walden, Simpson, Fletcher, Condit, Dooley, Hilliard, Pomeroy, Bishop, Baldacci, McIntyre, Etheridge, Boswell, Lucas of Kentucky, Baca, and Stenholm [ex officio].
Staff present: David Ebersole, Ryan Weston, Christy Cromley, Callista Bisek, Wanda Worsham, clerk; and John Riley.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. Ladies and gentlemen, the hearing of the Subcommittee on Risk Management, Research, and Specialty Crops to review H.R. 4541, the Commodity Futures Modernization Act of 2000, shall come to order.
I know that some of my colleagues on both sides will be here shortly, after they complete their vote, but several of them indicated that it would be perfectly all right if I went ahead with my opening statement and they would be glad to read it in the record. [Laughter.]
Page 9 PREV PAGE TOP OF DOC So, I will do that.
Welcome to today's hearing to review H.R. 4541, the Commodity Futures Modernization Act of 2000. This hearing will provide our members the opportunity to hear comments from representatives of the President's Working Group regarding this legislation. Today's witnesses include many who have worked to help create this responsible approach to futures and over-the-counter market modernization.
The President's Working Group report on over-the-counter derivatives was requested by the House and Senate Agriculture Committee chairmen in September 1998 and presented to the committee in November 1999. The report laid the groundwork for many of the legal certainty provisions and other provisions included in H.R. 4541.
The President's Working Group report pointed out two other issues that deserved the subcommittee's close attention. Regulatory relief for domestic futures exchanges is of great importance to ensure that U.S. futures exchanges can compete globally. Chairman Greenspan said it most clearly in some of his past testimony:
Already the largest futures exchange in the world is no longer in America's heartland. Instead, it is now in the heart of Europe. To be sure, no U.S. exchange has yet lost a major contract to a foreign competitor, but it would be a serious mistake for us to wait for such unmistakable evidence of the loss of international competitiveness before we act.
While the President's Working Group report did not give details on regulatory relief for futures exchanges, it did conclude that the Commodity Futures Trading Commission should provide appropriate regulatory relief for the exchange-traded financial futures. The CFTC took the initiative to develop a far-reaching staff proposal to provide regulatory relief for domestic futures exchanges. I am extremely impressed with the CFTC commitment to work with the industry and with other members of the President's Working Group in creating its proposal. H.R. 4541 incorporates much of the framework put forward by the CFTC.
Page 10 PREV PAGE TOP OF DOC The final aspect of the Commodity Exchange Modernization I would like to address is the Shad-Johnson Accord. The President's Working Group members believe that the current prohibition on single stock futures could be repealed if issues about the integrity of their underlying security market and regulatory arbitrage are resolved. Chairman Combest, Ranking Member Stenholm, Chairman Bliley and I all signed a letter to Chairman Levitt of the SEC and Chairman Rainer of the CFTC asking them to create and present a plan regarding the Shad-Johnson. The agencies agreed that they would share jurisdiction on regulating these products, that dual trading would be banned, that margins would be set equivalent to the levels on options markets, and that the SEC would enforce the insider trading laws on these products.
I also requested a GAO report that identified three areas of significant concern: insider trading, margins, and suitability. Many of the issues addressed by the agencies and by the GAO report are incorporated into the bill by importing security law provisions into futures markets and providing a level playing field for all markets.
While it may be difficult, we shall make a strong attempt to see this legislation pass the House. Now that the banking modernization has been dealt with, it is time for the financial industry to move on to CEA modernization. I plan to hold a subcommittee markup before the end of June. Senator Lugar and Senator Gramm, along with Senator Fitzgerald, have introduced a Senate bill and are also striving to hold hearings soon. We all are on an expedited time frame to pass the legislation during this Congress. I have made it clear that I am interested in a comprehensive bill, and I believe this bill substantially addresses the most important reforms discussed in my previous subcommittee hearings. For the first time, members of the President's Working Group, many of the futures exchanges, and many over-the-counter parties have agreed on a majority of the bill.
America's financial industry is involved in a global battle. If the U.S. futures exchanges and the over-the-counter industry are to compete with new electronic exchanges and other foreign competition such as EUREX we need to send a clear message that the United States will have a fair and competitive regulatory system.
Page 11 PREV PAGE TOP OF DOC I look forward to the testimony today.
Members who have opening statements may have them included in the record at this time.
[The prepared statements of Members follow:]
PREPARED STATEMENT OF HON. BILL BARRETT, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF NEBRASKA
Thank you, Mr. Chairman, for holding this hearing to review the Commodity Futures Modernization Act of 2000. 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 provide legislation that will discourage fraud and manipulation, but encourages technology, competition and a sound business environment.
Mr. Chairman, as we take note of the testimony given by our witness panel today, we must keep in mind the importance that technological advancements have in this discussion. It is critical that we continue to examine the tools that are being used in the futures markets. It is very important that our U.S. exchanges are capable of competing with foreign exchanges on a level playing field. As Congress, we must also remember that technological advancements along with market innovations will require this committee to continue to review the effectiveness and efficiency of current regulations.
Our producers are becoming more involved in futures markets. It is important that we establish regulations that are fair and will allow our farmers to use the futures market as intended. In my home State of Nebraska, I try to encourage the use of the futures market to provide producers with yet another valuable risk tool. This legislation properly addresses the many concerns of Over-the-Counter Derivatives, Agriculture Trade Options, the Shad-Johnson Accord and many other elements involved in financial markets.
Page 12 PREV PAGE TOP OF DOC Once this reauthorization is complete, I expect the CFTC to regulate the U.S. futures and related markets and protect the interests of those who use the markets.
I look forward to hearing testimony from each witness here today.
PREPARED STATEMENT OF HON. CHARLES W. STENHOLM, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. Chairman, thank you for this hearing and for your work in developing the compromises embodied in H.R. 4541. Your persistence in pushing affected parties toward agreement has borne fruit and, thanks in large part to your efforts, the gap that has delayed our action has narrowed considerably. You and the parties involved are to be commended. I agree that the unanimity of the President's Working Group regarding OTC derivatives is an important development that has clarified the solution to our task, and I am grateful for their efforts in developing their report.
While it is unfortunate that agreement remains elusive regarding the proper manner in which to reform the Shad-Johnson Accord, your efforts have forced progress in this area as well. While just a year ago the SEC testified in favor of the preservation of the accord and securities exchange representatives testified that there is neither need nor purpose for futures contracts on single equities, we now have the CFTC and the SEC working together on developing a common approach to Shad-Johnson reform. Securities exchanges are debating the details-rather than the very idea of the regulation of single stock futures.
Mr. Chairman, the bill you have introduced has produced even further progress. Though the CFTC and SEC cooperation has yet to produce a specific proposal, the SEC's detailed criticism of your effort has allowed us to ascertain specific concerns that heretofore have not been voiced. The bill demonstrates a good-faith attempt to address the general concerns expressed by the SEC and the securities exchanges. While I find it unfortunate that the SEC has chosen such a condemning tone in its testimony regarding the bill, the criticisms are quite specific, and may, as a result, prove helpful as we move forward. I hope that the industry and the two agencies will continue to strive for a solution that allows for Shad-Johnson reform.
Page 13 PREV PAGE TOP OF DOC Mr. Chairman, I feel that we are close to a solution in many areas, and I look forward to working with you and other members of the subcommittee, the full committee, and the other committees of jurisdiction to develop legislation that modernizes the Commodity Exchange Act.
PREPARED STATEMENT OF HON. SANFORD D. BISHOP, JR., A REPRESENTATIVE IN CONGRESS FROM THE STATE OF GEORGIA
I thank Chairman Ewing and Ranking Member Condit for holding this hearing today to review the Commodity Modernization Act of 2000.
As we move forward on this legislation, I hope that at the end of the process, we can have legislation that provides legal certainty for the Over-the-Counter derivatives industry and also gives regulatory relief for futures exchanges. In addition, the final product must reform the Shad-Johnson Accord.
I recognize that if the U.S. futures exchanges and the OTC industry are to compete with new electronic exchanges and other foreign competition, Congress must put in place legislation that allows for implementation of a fair and competitive regulatory system for futures markets and OTC markets.
In addition, I support keeping agricultural products under the purview of the Commodity Exchange Act because of the possibility that because the products have a finite supply, their markets could be manipulated.
Finally, I support provisions in this legislation that retain the CFTC emergency powers over agricultural instruments. I also support the language that ensures that producer groups have adequate input in the rule-making process at CFTC.
I look forward to the testimony of the panelists assembled here today.
PREPARED STATEMENT OF HON. DEBBIE STABENOW, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF MICHIGAN
Page 14 PREV PAGE TOP OF DOC Mr. Chairman and Ranking Member Condit, thank you for bringing the committee together today to discuss H.R. 4541, the Commodity Futures Modernization Act of 2000, authored by Chairman Ewing. This committee has been reviewing the reauthorization of the Commodity Exchange Act for some time and we have now taken a step forward by considering Mr. Ewing's legislation.
The legislation before us contains three main components: it modernizes the regulation of exchange-traded futures, establishes legal certainty for over-the-counter derivatives products, and reforms the Shad-Johnson accord. It is a credit to Chairman Ewing and Ranking Member Condit's leadership that this bill is the product of a year's worth of hearings and consensus building.
I would like to thank today's witnesses not only for providing testimony in today's hearing, but also for their efforts, and the efforts of their organizations, in the process that has produced today's bill, as well. I welcome Mr. C. Robert Paul, General Counsel at the Commodity Futures Trading Commission, Mr. Lewis A. Sachs, Assistant Secretary for Financial Markets at the U.S. Department of the Treasury, Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the, Federal Reserve System, and Ms. Annette L. Nazareth, Director of the Division of Market Regulation, Securities and Exchange Commission. I appreciate any insight you might offer as the subcommittee considers the Commodity Futures Modernization Act of 2000.
Mr. EWING. Our only panel today is Mr. C. Robert Paul, General Counsel, Commodity Futures Trading Commission; Mr. Lewis A. Sachs, Assistant Secretary for Financial Markets, U.S. Department of the Treasury; Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors, Federal Reserve System; and Ms. Annette L. Nazareth, Director of the Division of Market Regulation, Securities and Exchange Commission. Thank you all for being here. Thank you for participating, and we will start with you, Mr. Paul.
Page 15 PREV PAGE TOP OF DOCSTATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION
Mr. PAUL. Thank you, Chairman Ewing, and members of the subcommittee. I appreciate the opportunity to testify before you today on behalf of the Commodity Futures Trading Commission and to discuss the important issues addressed in H.R. 4541. The Commission commends Chairman Ewing on his efforts to modernize the Commodity Exchange Act and to act on the recommendations of the President's Working Group.
Timely implementation of such recommendations is essential to enable U.S. markets to keep pace with the technological changes occurring in markets around the world.
The Commission welcomes the provisions in your bill designed to enhance legal certainty for the over-the-counter derivatives by excluding from the CEA certain bilateral transactions entered into on a principal-to-principal basis for eligible counterparties. Legal certainty is a crucial consideration when parties to OTC derivatives contracts decide with whom and where to conduct their business.
It is critically important that we allow our markets to exploit new technologies without undue regulatory constraints if they are to remain competitive with foreign markets.
The Commission believes that H.R. 4541 will create an environment in which innovative systems can be developed and implemented. This bill would permit clearing of OTC derivatives and would create a mechanism for the CFTC to regulate facilities that clear such instruments. We look forward to working with Congress, other Federal regulators, and the industry to develop a system of clearing financial market transactions that will allow for improved risk management and enhanced stability of the OTC derivatives markets. The CFTC hopes that these statutory changes will lead to a dialog that will achieve the maximum level of reciprocity among financial regulators for the clearing organizations under their respective jurisdictions.
Page 16 PREV PAGE TOP OF DOC H.R. 4541 diverges, however, from the recommendations of the President's Working Group by codifying an exemption from most provisions of the Commodity Exchange Act for transactions in energy and metal commodities. In recommending an exclusion from the CEA for financial derivatives, the working group differentiated between trading financial products and non-financial products. The working group noted that the activities of most financial derivatives dealers were already subject to direct or indirect Federal oversight. The same cannot be said for those trading energy or metal derivatives.
The CFTC has already exempted many types of energy trading from the provisions of the Commodity Exchange Act. But the exemption for energy commodities included in H.R. 4541 expands the scope of the Commission's existing exemptions. The Commission's 1993 energy exemption is confined to parties with a capacity to make or take delivery, but H.R. 4541 would extend the exemption beyond those acting in a commercial capacity to encompass all eligible contract participants as defined in the bill.
The Commission's energy exemption is also limited to transactions in which the material economic terms are subject to negotiation and which cannot be cleared. This bill places no limits on standardization of contract terms and specifically permits clearing. Consequently, unlike the Commission's energy exemption, this bill would exempt transactions that mimic those that are conducted in a traditional exchange environment.
Because the Commission has witnessed the manipulation of prices on certain metals, we believe that futures and options transactions in these commodities require full regulatory oversight by the CFTC to protect the markets and their participants from unlawful practices. The Commission thinks that it would be appropriate to review contracts on a case-by-case basis using the criteria set forth in our regulatory reform proposal which considers risk of manipulation, the degree to which a contract serves a price discovery function, and characteristics of the market participants. The Commission intends to continue to work with the chairman and members of the subcommittee to find an acceptable resolution of the regulatory treatment of energy and metal commodities.
Page 17 PREV PAGE TOP OF DOC In February, a staff task force of the Commission proposed far-reaching and fundamental changes to modernize Federal regulation of futures and options markets and to relieve domestic exchanges from unnecessary regulatory requirements. Last week the Commission approved the proposed regulatory reform package for publication in the Federal Register and announced that it will hold two public hearings on the proposal.
H.R. 4541 attempts to codify much of the Commission's regulatory reform proposal, and we welcome Chairman Ewing's support of the Commission's initiative to provide a form and degree of regulatory oversight that is appropriate to the needs of the markets and their participants. CFTC staff will shortly provide to this subcommittee a detailed comment letter comparing our proposed regulatory framework with the relevant provisions of H.R. 4541.
For example, the Commission is concerned that the bill's negotiated enforcement provisions could weaken our enforcement authority.
Finally, H.R. 4541 addresses the issue of equity futures contracts and amends the Shad-Johnson Accord. The working group recommended that the CFTC and the SEC work together to determine whether and how the accord should be amended. The agencies agree in principle that equity futures should be available to the marketplace, but we acknowledge fundamental disagreement concerning the appropriate legislative approach.
With respect to futures regulatory issues relating to single stock futures products, the Commission does not object to the provisions of H.R. 4541.
Again, the Commission appreciates the opportunity to offer our views, and I would be happy to answer any questions.
[The prepared statement of Mr. Paul appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
Page 18 PREV PAGE TOP OF DOCSTATEMENT OF LEWIS A. SACHS, ASSISTANT SECRETARY, FINANCIAL MARKETS, U.S. DEPARTMENT OF THE TREASURY
Mr. SACHS. Good morning, Mr. Chairman and Mr. Stenholm and members of the subcommittee. I appreciate the opportunity to appear before you today to discuss H.R. 4541. The introduction of this legislation is an important step in the modernization of the regulatory structure of the U.S. derivatives markets. I would like to commend you, Mr. Chairman, for the leadership you have demonstrated in addressing these complex but very important issues.
I would like to focus my remarks this morning on H.R. 4541 and its potential effect on the regulatory structure of the derivatives and other financial markets.
In previous testimony before this subcommittee and in my prepared remarks for today's hearing, I have highlighted the importance of the derivatives markets to our economy. Very briefly, when used properly, derivatives can help businesses, farmers, and financial institutions hedge their risks efficiently and effectively. They can promote a more efficient allocation of capital across the economy, and by enabling more sophisticated management of assets, derivatives can lower mortgage payments, insurance premiums, and other costs for American businesses and consumers.
While the current framework in the United States remains outdated, markets overseas are developing in a legal and regulatory environment that allows greater efficiency and transparency. The challenge for this subcommittee and Congress is to establish a regulatory regime that will strike a balance between allowing the economy to realize more fully the benefits of derivatives and, at the same time, ensuring the integrity of the underlying markets, providing appropriate protection for retail customers, and where possible, taking steps to mitigate systemic risk.
Page 19 PREV PAGE TOP OF DOC There are four primary objectives that we have with respect to legislation in this area: first, to reduce systemic risk in the OTC derivatives market by removing legal impediments to the development of appropriately regulated clearing systems; second, to promote innovation by providing legal certainty for OTC derivatives and electronic trading systems; third, to protect retail customers by ensuring that appropriate regulations are in place to deter unfair practices in markets in which they participate; fourth, to maintain U.S. competitiveness by providing a modernized framework that will lead those engaged in the financial services industry to continue the operations of their businesses here in the United States and thereby assuring the continued leadership of our capital markets.
Given the scope of this bill, today I would add a fifth important objective, that is to protect the integrity of the markets underlying the derivatives in question, in particular, the markets for securities.
A balanced bill should meet these important objectives.
Let me now turn to H.R. 4541. While much of my testimony today will focus on specific concerns that we have with certain provisions of this bill, we are supportive of your efforts, Mr. Chairman, to ensure that these issues are addressed in a timely manner. In that spirit, we have identified a number of specific concerns in the three main components of this bill that we believe must be addressed in order to ensure that the final legislation satisfies the objectives set forth by the President's Working Group.
With respect to OTC derivatives, this bill largely incorporates the recommendations of the working group. We do, however, have two concerns in this area. Our primary concern relates to the treatment of clearinghouses. While well-designed clearinghouses can help to reduce systemic risk, they also tend to concentrate risks and certain responsibilities for risk management in a central counterparty or clearinghouse. Therefore, appropriate regulation of clearing systems is essential to ensure that they, indeed, serve to mitigate systemic risk.
Page 20 PREV PAGE TOP OF DOC We have two concerns with the approach taken in this bill. First, regulatory oversight is optional on the part of the clearinghouse. Second, the exclusive jurisdiction of the CFTC may preclude securities regulators from maintaining oversight of organizations that clear securities related transactions.
Consistent with the working group's report, we believe H.R. 4541 should be amended to make regulation of clearinghouses mandatory and to permit the regulation to be carried out by the appropriate functional regulator.
Our second concern relates to part of the definition of eligible participant. The bill, as drafted, maintains a lower threshold for the definition of eligible participant than that recommended by the working group. We maintain that participation in this market should be limited to institutions or individuals with substantial resources.
Let me now turn to the section of the bill addressing reform of the Shad-Johnson Accord. As you noted in your opening statement, Mr. Chairman, the members of the working group agreed that the current prohibition on single stock futures could be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. Our view is unchanged.
The provisions contained in this bill regarding futures on nonexempt securities are a good starting point, although a number of issues remain unresolved.
While we have no objection to the introduction of single stock futures, it is vitally important that the integrity of the underlying markets be preserved and that these instruments not be used as a means to avoid the regulation of the cash markets. Therefore, we continue to be supportive of efforts by the SEC and CFTC to reach an agreement on a regulatory framework for these products.
The third component of this bill addresses regulatory relief for the futures exchanges. The Treasury Department continues to support the view that it is appropriate to review from time to time existing regulatory structures to determine whether they continue to serve valid regulatory functions. Like the OTC markets, exchange trading of derivatives should not be subject to regulations that do not have a public policy justification.
Page 21 PREV PAGE TOP OF DOC I would note that there may be some unforeseen consequences to legislating such regulatory relief. While we are supportive of appropriate regulatory relief for futures exchanges, we suggest that certain aspects of that relief may be more appropriately provided through administrative action.
More specifically in the legislation, we are concerned with provisions regarding what are called exempt boards of trade. The potential impact of this provision on the Government securities market is of particular concern to the Treasury Department. In 1986, Congress passed the Government Securities Act to provide an appropriate regulatory framework for the Government securities markets in direct response to a number of problems that had arisen in that market. In 1993, in response to incidents of wrongdoing in Treasury auctions, Congress strengthened these laws to provide additional protection against market abuses.
Under some interpretations, H.R. 4541 could allow futures on Government securities to escape most of the provisions of the CEA that currently apply to them, but would also block regulation under the Government Securities Act. In addition, securities market participants, that are currently regulated under the Government Securities Act, could potentially restructure themselves as exempt boards of trade to evade regulation under both statutes. This has the potential to undermine the laws that Congress put in place in recent years that were designed to uphold and strengthen the integrity of the Government securities market. Any reduced confidence in that integrity could lead to higher financing costs for the Treasury and thus an increased burden on American taxpayers. For these reasons, we strongly recommend that those provisions of the bill related to exempt boards of trade be removed or amended to preclude the trading of securities related products on those systems.
Although not part of this bill, I would like to take this opportunity to again strongly urge Congress to adopt the President's Working Group recommendations regarding the treatment of these instruments in cases of bankruptcy or insolvency. Rarely are there tangible steps the Government can take that could have a meaningful impact on the mitigation of systemic risk. Enacting the recommendations of the working group designed to clarify the treatment of these instruments in bankruptcy is one of those steps.
Page 22 PREV PAGE TOP OF DOC Finally, Mr. Chairman, you have gone to great lengths to build consensus among the members of this committee, the working group, and market participants on a difficult set of issues. We look forward to working with you to ensure that much needed legislative changes are made that will promote innovation, protect retail customers, reduce systemic risk, and maintain U.S. competitiveness.
Thank you, and I would be happy to take any questions you may have.
[The prepared statement of Mr. Sachs appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Sachs.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. PARKINSON. Thank you, Mr. Chairman, members of the committee. I am pleased to be here to present the Federal Reserve Board's views on legislation to modernize the Commodity Exchange Act. The Board continues to believe that such legislation is essential. To be sure, the CFTC has recently proposed issuing regulatory exemptions that would reduce legal uncertainty about the enforceability of OTC derivatives transactions and would conform the regulation of futures exchanges to the realities of today's marketplace.
These administrative actions by no means obviate the need for legislation, however. The Board commends this committee for introducing comprehensive legislation that addresses these critical issues.
In my remarks today, I shall focus on the three principal areas that the legislation covers: OTC derivatives, regulatory relief for U.S. futures exchanges, and repeal of the Shad-Johnson restrictions on the trading of single stock futures.
Page 23 PREV PAGE TOP OF DOC The provisions of H.R. 4541 that address OTC derivatives are generally consistent with the conclusions and recommendations contained in the President's Working Group's November 1999 report. However, the Board is troubled by a provision that might leave uncertainty about whether some electronic trading systems for financial contracts between professional counterparties were subject to the CEA. Specifically, restricting exclusions for transactions conducted on electronic trading facilities to bona fide principal-to-principal transactions is unnecessary and undesirable.
In addition, H.R. 4541 does not require Government oversight of clearing organizations for OTC derivatives, contrary to the recommendation of the PWG. The Board continues to believe that such oversight is appropriate.
The working group did not make specific recommendations about the regulation of traditional exchange traded futures markets that use open outcry trading or that allow trading by retail investors. Nevertheless, it called for the CFTC to review the existing regulatory structures.
The Board supports the broad outlines of the new approach to the regulation that the CFTC issued for public comment last week. For some time the Board has been arguing that the regulatory framework for futures trading, which was designed for the trading of grain futures by the general public, is not appropriate for the trading of financial futures by large institutions. The CFTC's proposals recognized the current one-size-fits-all approach to regulation of futures exchanges is inappropriate and they generally incorporate sound judgments regarding the degree of regulation needed to achieve the CEA's purposes.
Furthermore, the Board generally supports codification of the CFTC's proposals so as to provide the exchanges with greater certainty regarding future regulation. However, the Treasury Department is concerned that the exempt board of trade provisions might have unintended consequences that could reduce the effectiveness of the existing regulatory framework for the trading of Government securities. It may be prudent, therefore, to limit the codification of the exempt board of trade provisions at least so that markets currently regulated under the Government Securities Act of 1986 are not affected. This would allow the CFTC to address any unintended consequences for the regulation of Government securities by changing the terms of its exemptions.
Page 24 PREV PAGE TOP OF DOC The working group concluded that current prohibition on single stock futures can be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. The Board believes that these issues can and should be resolved through negotiations between the CFTC and the SEC. The Congress should continue to urge the two agencies to settle their remaining differences so that investors have the opportunity to trade single stock futures both on futures exchanges and on securities exchanges.
In conclusion, the Board continues to believe that legislation modernizing the Commodity Exchange Act is essential. The Board appreciates this committee's efforts to foster the consensus necessary to enact legislation. Although some difficult issues remain unresolved, H.R. 4541 represents very significant progress toward that goal.
Thank you. I will be pleased to take any questions.
[The prepared statement of Mr. Parkinson appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Parkinson.
STATEMENT OF ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. NAZARETH. Thank you, Chairman Ewing and members of the subcommittee. I am pleased today to appear to testify on behalf of the Securities and Exchange Commission as you consider H.R. 4541, the Commodity Futures Modernization Act of 2000.
My testimony addresses two topics of significant interest to the Commission.
First, the Commission reiterates its strong support for the implementation of the recommendations by the President's Working Group on Financial Markets related to legal certainty for over-the-counter derivatives markets.
Page 25 PREV PAGE TOP OF DOC Second, I will address the investor protection and market integrity issues raised by single stock and narrow based stock index futures and the Commission's serious concerns with the regulatory approach contained in H.R. 4541.
As you know, last year, the working group recommended amending the Commodity Exchange Act to ensure legal certainty for OTC derivatives products. One cannot understate the historic significance of the consensus achieved. The combined regulatory expertise of four of the leading U.S. financial regulators determined that the report's recommendations urgently required implementation. Given the critical role that these products play in our capital markets, one can think of few more important issues for congressional consideration. The Commission, however, has some concerns about the ways in which H.R. 4541 differs from the working group's recommendations in a few key respects. These concerns are set out in greater detail in my written statement.
The Commission continues to strongly support the immediate implementation of the working group's unanimously agreed upon recommendations. Moreover, we continue to urge the subcommittee to pass the much needed provisions on legal certainty for OTC derivatives regardless of whether consensus is reached on other issues in the bill. We appreciate the efforts of this subcommittee in furtherance of this goal, and we are committed to working with you as you continue to craft this bill.
I would now like to speak about single stock futures. Disparities between futures and securities regulation, as well as the ease with which single stock futures are expected to substitute for securities, make designing a legislative framework a difficult task. However, the Commission strongly believes that single stock futures could trade if certain regulatory issues are resolved. More importantly, we believe these issues are resolvable.
In pursuit of the resolution of these issues, the staffs of the CFTC and the SEC engaged in extensive discussions on this topic. Although we were not able to craft joint legislation in this short period of time, we did reach agreement on fundamental principles for creating a framework for single stock futures. Most important among these principles was that, given the legitimate regulatory interests of both the SEC and the CFTC in these products, single stock futures should be subject to joint regulation by the agencies. I appreciate the efforts by the CFTC staff in working to reach these significant agreements.
Page 26 PREV PAGE TOP OF DOC To further the goal of permitting these products to trade under an appropriate framework that would ensure investor protection and market integrity, the SEC staff has formulated a plan under which these products could trade. This plan reflects principles that we believe are necessary to any appropriate regulatory framework.
In addition to joint regulation of single stock futures as securities and futures, we believe that it is crucial for any legislative framework to encourage fair competition among markets by, for example, including mechanisms to harmonize the regulatory requirements across the securities and commodities markets, particularly those related to margin. Competitive market forces, rather than Government regulation, should pick the winners and losers.
Legislation also should allow the same single stock futures to be listed on multiple exchanges. This avoids any one market having an exclusive franchise by forcing all markets to compete for investors' business.
Finally, the Commission's role in maintaining the integrity of the securities markets must be preserved. Single stock futures are intended to be a retail product. Investors in those products deserve the same protections that have applied to their investments in other securities for over 6 decades.
Unfortunately, we do not believe this bill sufficiently meets these goals. More specifically, the bill does not embrace joint regulation of these products by the SEC and the CFTC. In addition, it provides the SEC with only an illusory role in maintaining market integrity and customer protection. Moreover, the bill lacks the provisions that would encourage fair competition between markets offering these products. I repeat, though, that we believe these goals can be accomplished and we would be happy to work with the subcommittee on crafting a workable alternative framework.
Once again, the Commission appreciates the efforts that you have made in bringing these derivatives issues to the forefront. We look forward to working with the subcommittee to craft a modern legislative approach to these issues. Thank you.
Page 27 PREV PAGE TOP OF DOC [The prepared statement of Ms. Nazareth appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Ms. Nazareth.
I want to recognize the ranking member of the full Agriculture Committee, Mr. Stenholm.
Do you have a statement or a comment you would like to make?
OPENING STATEMENT OF HON. CHARLES W. STENHOLM, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. STENHOLM. Yes, Mr. Chairman. Thank you very much. Thank you for this hearing today and for your work in developing the compromise embodied in H.R. 4541. Your persistence in pushing affected parties toward agreement has borne fruit and, thanks in large part to your efforts, the gap that has delayed our action has narrowed considerably. You and the parties involved are to be commended. And I agree that the unanimity of the President's Working Group regarding over-the-counter derivatives is an important development that has clarified the solution to our task, and I am grateful for their efforts in developing their report.
While it is unfortunate that agreement remains elusive regarding the proper manner in which to reform the Shad-Johnson Accord, your efforts have forced progress in this area as well. While just a year ago, the SEC testified in favor of the preservation of the accord and securities and exchange representatives testified that there is neither need nor purpose for futures contracts on single equities, we now have the CFTC and the SEC working together on developing a common approach to Shad-Johnson reform. Security exchanges are debating the details rather than the very idea of the regulation of single stock futures.
Mr. Chairman, the bill you have introduced has produced even further progress, though the CFTC and SEC cooperation has yet to produce a specific proposal. The SEC's detailed criticism of your effort has allowed us to ascertain specific concerns that heretofore have not been voiced. The bill demonstrates a good faith attempt to address the general concerns expressed by the SEC and the securities exchanges. While I find it unfortunate that the SEC has chosen such a condemning tone in its testimony regarding the bill, the criticisms are quite specific and may, as a result, prove helpful as we move forward.
Page 28 PREV PAGE TOP OF DOC I hope that the industry and the two agencies will continue to strive for a solution that allows for Shad-Johnson reform. Mr. Chairman, I feel that we are close to a solution in many areas, and I look forward to working with you and other members of the subcommittee, the full committee, and the other committees of jurisdiction to develop legislation that modernizes the Commodity Exchange Act.
Thank you, Mr. Chairman. I have some detailed questions that I would feel would be better submitted to the witnesses in writing, and I would be happy to do so.
Mr. EWING. Without objection, they will be submitted. Thank you for your statement, and we would ask that the participants try and answer those questions in a very timely manner and return them to us.
I am certainly committed to moving legislation this year. I think we have to look realistically at the amount of time and buildup that there has been to come to the consensus that we have today. We all know that we will have a new administration. We will have a new Congress. We will have new leadership. We could very well lose much of the momentum if we fail to act on legislation this year.
I also hesitate to say, well, we will pass those parts which we agree on. You know, it is pretty hard to pat yourself on the back when you have just done the easy work and left all the tough decisions to somebody else. I think we have come too far for that. I said in my opening statement that we need a comprehensive bill, one that is fair to all the parties, as well as we can make it today. I would just reiterate that to all of you at this table because you have such an important part to play in the success of this bill or the Senate version of the bill or another version that may emerge.
I would just address this to Ms. Nazareth. I do not think that anyone in this room has any question that Shad-Johnson is probably the biggest issue in this bill.
Ms. NAZARETH. I would agree with that.
Page 29 PREV PAGE TOP OF DOC Mr. EWING. Yes. You do not have to answer this, but it appears to me that we have asked, the chairmen of the full committees have asked in both the Senate and the House for the regulatory bodies to work together, and they have had a lot of time. Are you saying to me today that there is not enough time for an agreement between the CFTC and the SEC on this matter?
Ms. NAZARETH. I believe that we have used the time that we had very constructively and that significant progress has been made. I think that where we left off in our recent discussions was that we had general agreements in principle, and I believe that the Commission staff crafted a framework that we believed incorporated those agreements into a document, which we have shared with the staffs of this subcommittee. It is fair to say that that is an unnegotiated document. We did really run very short of time at that point, and it is fair to say that we have not received any comments from the CFTC staff on that document.
While again I can say that we do have substantial agreement on a number of significant points, one of our general concerns was this sort of top-down versus bottom-up approach, which I can explain to you. The Commission wanted to and continues to believe that we should, take the position that these products are both futures and securities and therefore subject to the regulation of both agencies. Therefore, we will say what does not apply. The CFTC preferred the approach of saying that these are futures and for certain purposes will be securities, so why not just pick out what sections of the securities laws do apply. Now, obviously, no matter which way you approach those negotiations, ultimately if you reach consensus, you should be talking about the same body of law and provisions that do apply. So, I think that we are ultimately going to get there, although perhaps coming at it from different approaches.
What the challenge was for the CFTC staff, as we left the negotiations, was that we have taken an approach that does provide that these are securities subject to our core provisions. We specify where we will either rely on the CFTC regulations or where the SEC provisions would be inapplicable, and I do not believe that the CFTC staff had sufficient time, given the complexity of, frankly, both of our frameworks to absorb the implications of the draft that we provided.
Page 30 PREV PAGE TOP OF DOC Mr. EWING. When we were visiting with some of the constituents that you regulate and we say that both bodies would regulate, they kind of roll back and fall over. Regulation is important, must happen, but it can also be a burden. Have the two agencies talked about trying to avoid the problems of double regulation in a dual regulatory system so that the regulated can operate with as much efficiency as possible?
Ms. NAZARETH. I think that was a substantial concern. I would say that the main part of our focus was determining how we could streamline the process and how we could coordinate effectively. I think that really was the biggest part of the effort on the deregulatory provisions and the coordination provisions. But I should let Bob Paul speak to that as well.
Mr. PAUL. Mr. Chairman, it is that issue that precisely explains why the CFTC took the position that Ms. Nazareth articulated. We felt that although the agencies agreed that joint regulation is essential because of the important interests of both markets, both on the securities and the futures side, we felt that it is equally important that whatever regulatory structure we put together imposes the least cost and the least burdens on both types of exchanges. So, we wanted to ensure that joint regulation did not mean duplicative regulation. That is why we advocated identifying specific provisions in each of our acts that would need to be exported to the other regulatory regime rather than to bring these products under the full panoply of the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisors Act of 1940 and at the same time remain subject to the Commodity Exchange Act. That is what I meant when I referred to our fundamental disagreement on legislative approach.
But Ms. Nazareth is also correct that we did agree on many specifics, some of which were outlined in a March 2nd letter from Chairman Levitt and Chairman Rainer to the respective committee chairs. We believe that there is a resolution to be worked out, and we think that the subcommittee has taken a giant step forward in helping to resolve the issue.
Page 31 PREV PAGE TOP OF DOC Mr. EWING. I realize that the red light is blinking, but before I lose track of the trail I am on here, Mr. Paul, does your staff have time to work with the SEC staff to try and come to an agreement?
Mr. PAUL. Absolutely. This has been one of our highest priorities since last December when we initiated discussions with the SEC staff. We are prepared to work 24 hours a day, 7 days a week, to resolve the issue.
Frankly, we were making a lot of progress. However, I think it is the philosophical approach on how we treat these things in the statute that has led to, in essence, an impasse that we feel that perhaps Congress can help us to break.
Mr. EWING. You put the hard work back here.
Thank you both very much. My time is up.
Mr. Stenholm, do you have any questions?
Mr. STENHOLM. No.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Mr. Chairman, I want to congratulate you for your bill. You have been a strong chairman of this subcommittee. This has been a focus point of yours. I am not saying that I am prepared to vote aye on every provision in your bill, but you wanted to move this. You have got the bill out there that does it, and I think you have advanced the debate a great deal.
I would like to continue on the track you were on, Shad-Johnson. Conceptually I am hung up on how you can regulate a security one way and the derivative of that security another way. I have got a problem with that. Now, it seems to me that some of those issues have been addressed in the chairman's bill where SEC authority has been specifically designated.
We have learned a lot about this issue. We are a lot smarter than we used to be on it, but we would love consensus from you all for guidance. But if somebody needs to set policy and there is nobody else to do it, we will do it.
Page 32 PREV PAGE TOP OF DOC Ms. Nazareth and Mr. Paul, if you would specifically speak to that conceptual hang-up I have got and how the bill addresses it, or is this just something I should not even be worried about? I do not care who goes first. Mr. Paul, you can go first. Ms. Nazareth, you get cleanup this time.
Mr. PAUL. I think that the bill is a good starting point for how to resolve that issue by acknowledging that these products would be futures, but also recognizing the important concerns that the SEC would have as they relate to the underlying securities that the derivatives are related to.
I think that in the bill, by importing at least some of the most fundamental issues that are important for protection of securities markets, that is a very good way to begin to approach the issue.
Mr. POMEROY. If I might just try and clarify on that point.
Mr. PAUL. Sure.
Mr. POMEROY. A stock as opposed to an index. You know, you worry about internal manipulation specifically. You worry about consumer fraud, the other kind of basic things. Now, does the chairman's bill provide for SEC jurisdiction on those kinds of fundamental aspects of a security?
Mr. PAUL. I believe it does by specifically bringing over section 10(b) of the 1934 act which involves fraud, as well as section 16 which involves short swing profits, to prevent the insiders taking advantage of inside information. I think it captured some of the major ones.
We were very much interested in our dialog with the SEC over the first 5 months of this year and also identifying other issues that they thought were important to carry over into the futures markets. I think we made significant progress and were very sensitive to the SEC's concerns. The SEC does have a long and successful record in regulating the securities markets and we think that they had a number of legitimate concerns.
Page 33 PREV PAGE TOP OF DOC Our concern, however, was that rather than enumerating the specific provisions, the so-called core provisions that would need to be carried over, instead, as I think their proposal sets forth, they identified the non-core provisions. They identified the carve-outs rather than those that would apply. The problem with that approach is that those four statutes that I referred to are fairly extensive, and we feel it is incumbent upon this agency to be able to advise the subcommittee that those provisions that would be brought over to the futures side of the equation were all absolutely necessary and did not pose any undue burden on the exchanges.
Mr. POMEROY. So, you believe specific enumeration is clearer than carve-outs.
Mr. PAUL. Correct.
Mr. POMEROY. Gramm-Leach-Bliley, for example, takes a carve-out approach relative to State insurance regulation. The thing is a damnable mess. You try and read that statute and understand what it means. Lawyers are going to make money for years and years to come on that bill. [Laughter.]
I would like to do better on this one.
But enough of you. If we can move to Ms. Nazareth before my time totally expires. You have heard my questions and also Mr. Paul's comments. What are your responses?
Ms. NAZARETH. Yes. I appreciate your question. I think your question really hits on the heart of the issue. There are significant risks involved in establishing a framework in which regulation is significantly different between the underlying cash market for the securities and the derivatives market for the product. That is obviously where we have spent an enormous amount of time because we are very sensitive to the impact on the markets of having disparate regulation.
I want to take exception with one thing that Mr. Paul said. This is an example of what happens when you sort of cherry pick from one statutory regime and say, well, what do you want? Just tell me what provisions do you want. One example is the concern with market manipulation and insider trading. There is a reference in this bill to section 10(b), but it specifically refers to 10(b) only insofar as it relates to insider trading and front running. So, it does not relate to market manipulation.
Page 34 PREV PAGE TOP OF DOC We are very concerned about what we might miss in this process by picking certain sections. Also unfortunately, the securities laws are very complex. We appreciate the difficulty of going through this process because even our own staff spent weeks going through and saying, well, if we wanted to address a particular issue, is there a particular section of the securities law that we can point to such as 10(b). These concepts are sprinkled throughout the statute, and so we really felt that in order to adequately cover these issues and ensure that there was not essentially a regulatory disparity between the regulation of the derivative and the regulation of the security in the cash market, we decided to, in an abundance of caution, take the opposite approach.
But again, I think that ultimately when you are negotiating this, whether you start with everything except the following or tell me what is important, ultimately you should be able to arrive at what is core to your agenda, what is core to your framework, and what is necessary to ensure that retail investors continue to enjoy the protections that they have in 60 years for the underlying cash market
Mr. POMEROY. On that, one tiny follow-up.
Mr. EWING. Mr. Pomeroy, that is fine because I am going to be fairly liberal today because it is difficult to shut down. And I was with myself, so I must be with you.
Please do not go after the lawyers, though. [Laughter.]
Mr. POMEROY. No, no. I am just thrilled to hear you are a liberal today. I am loving it. [Laughter.]
I have been waiting a long time.
Mr. EWING. This will be the only day. [Laughter.]
Mr. POMEROY. The carve-out versus enumerated list. That just might be where you two cannot agree just like as much as the chairman and I try to find common ground, there are times when we just cannot get there. That is a drafting issue.
Page 35 PREV PAGE TOP OF DOC What about the fundamental consumer protections? Do you have conceptual agreement on that which needs to be shared jurisdiction? Can you get there? Let us leave the drafting question aside for a minute. Ms. Nazareth and then Mr. Paul.
Ms. NAZARETH. I believe ultimately we have the same goals of investor protection and market integrity, so I have every confidence that ultimately we would converge towards the same provisions.
Mr. PAUL. I would agree with that. I think with respect to customer protection, I think we are very much on the same page on most issues. There are a few other details in the SEC proposal that we might take exception to, but I do not think those relate to customer protection.
Mr. POMEROY. Thank you. Thank you, Mr. Chairman.
Mr. EWING. Thank you for your questions.
Mr. EVERETT. Thank you, Mr. Chairman. Thank you for the work that you have done on this difficult situation.
Mr. Paul, the SEC is concerned over suitability requirements regarding futures securities. Let me point out that futures commission merchants must already follow a ''know your customer'' rule. In addition, H.R. 4541 requires a registered futures association to create a rule for FCMs regarding the suitability of a customer to purchase futures on securities.
Would you please explain the current ''know your customer'' rule and how the creation of an additional suitability rule would help protect customers on the single stock futures?
Mr. PAUL. Yes. Under the current ''know your customer'' rule that the National Futures Association administers to all of its registrants, which include futures commission merchants and introducing brokers and other associated persons that deal with customers, it requires that before opening an account, those NFA members must ascertain detailed information about each customer, including their age, their occupation, their business, their trading experience, total net assets as a way of gauging what their risk tolerance might be.
Page 36 PREV PAGE TOP OF DOC In addition to that, the ''know your customer'' rule of the NFA also buttresses the risk disclosure requirements of the CFTC rules in which customers are required, before opening an account, to sign an acknowledgement that they have been advised of and understand the risks inherent in futures trading. The concept behind that is that futures trading in general is highly risky and that it is not appropriate for all customers, and customers must decide, before they engage upon it, whether they fully understand the risk and are willing to undertake those risks.
That level of disclosure is probably higher than what you have on the securities side because on the securities side with the ''know your customer,'' it is premised on the idea that different securities have different levels of risk. Therefore, a broker is required to assess whether a particular customer is suitable for a particular investment based on what that broker knows about the customer.
On the futures side with the risk disclosure, we think all of our investments are very risky. Therefore, by giving the blanket disclosure, you need not reach the suitability criteria. However, in our discussions with the SEC, we had agreed that customer suitability would be an appropriate measure to carry over to the futures side and we endorse that prong of H.R. 4541. But it is also important to bear in mind that the suitability requirement applies specifically to recommendations by the broker to the customer and that the customer is still entitled to exercise their own judgment as to what they ultimately want to invest in.
Mr. EVERETT. Thank you.
Ms. Nazareth, in your testimony you state that the bill does not adequately harmonize securities and futures requirements related to single stocks. The Federal Reserve Board stated in its testimony today that it would work to ensure margin was adequately set. Why do you disagree that the Fed could harmonize margin, and since the House bill and the Senate bill differ in that regard, does the Senate bill meet those objectives?
Page 37 PREV PAGE TOP OF DOC Ms. NAZARETH. Our concern with the approach in the House bill was that it was, I believe, at the option of the Fed and the CFTC, whether or not to create an intermarket board that would harmonize the margin requirements. We believe, again, that the SEC obviously should play a significant role in ensuring that the margin levels are harmonized and are appropriate across markets. So, it was really more of a concern of ensuring that the SEC has an appropriate role and voice in that process as well.
Mr. EVERETT. And the Senate bill? Does that meet the requirements?
Ms. NAZARETH. I do not recall. Oh, it is done the same way in the Senate bill.
Mr. EVERETT. Oh, it is?
Ms. NAZARETH. I think so.
Mr. EVERETT. I thought they were different.
Then finally, with all due regard, the results of the reform of the temporary Shad-Johnson ban on the trading of equity futures products, SEC and the CFTC have had 18 years to develop a framework for the regulated exchange of trading these products. H.R. 4541 provides an additional year. I would just have to wonder if 19 years is not enough. How long should this committee wait?
Ms. NAZARETH. Well, I do not believe the parties have been working on it for 19 years. I certainly have not been at the Commission for 19 years, so I cannot speak directly to that issue.
Mr. EVERETT. Well, the chairman has made it clear that he intends to move this legislation this year, and I think that the Congress is ready to vote on it. So, I would encourage some resolution of this matter.
Mr. EWING. Thank you, Mr. Everett.
Page 38 PREV PAGE TOP OF DOC Mr. Etheridge.
Mr. ETHERIDGE. Thank you, Mr. Chairman. Mr. Chairman, let me thank you for your work and your interest in this area because it is important. Mr. Condit as well. Let me thank our panelists for being here today on an issue that is quite complex and one that certainly needs attention.
Let me raise the question and go back to something the chairman talked about a little earlier and approach it a little bit differently, if I may, in this area as it relates to this legislation. Let me ask the entire panel this question. Whoever wants to go first is fine. What would the implications would be on our market if Congress passed this legislation without the provisions changing the Shad-Johnson act? In other words, give us some understanding as to what our competitors abroad are doing in this area also, if you will, if it passed in that way.
Mr. PAUL. Well, if you would like me to go first, Congressman, the Commission does not have an official position on whether or not it would support this bill without Shad-Johnson. So, let me speak in my capacity as representative of Chairman Rainer who was a signatory to the President's Working Group.
Chairman Rainer's agreement to the recommendation of the President's Working Group is not predicated on resolving Shad-Johnson for single stock futures. However, we recognize that the working group recommended that Shad-Johnson issues should be resolved to remove the ban on single stock futures, and we think that is a very important prong of the working group report.
We also think it is extremely important, as the other panelists have testified, that legal certainty is brought to the OTC markets as soon as possible, that it is incumbent upon the U.S. markets.
Let me go further, though, and say that in supporting the working group recommendations, Chairman Rainer had asked that Congress provide a directive that the CFTC provide regulatory relief to the futures exchanges which would offset some of the advantages the OTC markets would get as a result of adoption of the President's Working Group report. In light of that, we think it is very important to try to at least lift the statutory ban on single stock futures that is currently in the Commodity Exchange Act, which is beyond our power. We have done as much as we can do through the regulatory relief proposal that was published this week, through our exemptive authority, but that authority is limited by the Shad-Johnson bar on single stock futures contained in our statute. So, we believe it is important that Congress give us a little bit of help on this.
Page 39 PREV PAGE TOP OF DOC So, as far as Chairman Rainer is concerned, we would encourage moving forward on Shad-Johnson, but we also agree with the other members of the working group that legal certainty should be brought to the over-the-counter markets.
Mr. SACHS. Congressman, I would concur with much of what Mr. Paul said. We agree with Chairman Ewing in that it is very important to make every effort to move forward with a comprehensive bill.
Having said that, if all efforts have been exhausted within a reasonable period of time, with respect to Shad-Johnson, we believe that it is vitally important that legislation move forward, at least with respect to clarifying legal certainty in the markets for over-the-counter derivatives.
Again, we strongly encourage this committee to move forward with a comprehensive bill, but it would be unfortunate to hold one market hostage because of some of the other provisions that may be more difficult. However, we are hopeful that those issues can be resolved.
I would also say that the third I do not know what to call it, but the third leg of this bill, the regulatory relief provisions, also make a substantial contribution to the futures exchanges in regards to helping them compete globally. There is an awful lot that is in this bill that is helpful to them, in addition to the Shad-Johnson provisions, although again we encourage a comprehensive approach.
Mr. PARKINSON. I think the Fed's position is very close to the one that Mr. Sachs just articulated. The Board for many years has been urging the Congress to deal with the legal uncertainty issues regarding OTC derivatives. We also have been urging the Congress for years to give the futures exchanges the regulatory relief that they need. Those same issues were addressed in the working group's report, obviously in greater detail in the case of the OTC derivatives issue.
Page 40 PREV PAGE TOP OF DOC But also I would note the report said that the working group as a whole believes that the enactment of its recommendations with respect to OTC derivatives should be accompanied by explicit authority for the CFTC to provide appropriate regulatory relief for exchange traded financial futures. So, I think we think those issues are very important also.
With regard to Shad-Johnson, certainly I think the committee should do everything it can to pass comprehensive legislation, but if that does not prove possible, the OTC derivatives and regulatory relief portions are so important that I think those should go forward, even if unfortunately we cannot get the Shad-Johnson issues resolved.
Ms. NAZARETH. I agree with Mr. Sachs and Mr. Parkinson. I think that the Commission is very supportive of the implementation of the sections of the bill with respect to legal certainty. We appreciate the interest of the CFTC in being able to achieve some regulatory relief for the futures markets, and we remain committed to continuing to work on crafting an appropriate framework for the trading of single stock futures. But if the ability to achieve that goal is not within the time frame that has been set by this committee, we would prefer that issue be severed from this bill so that the other sections which we believe are very important, and which we strongly support, could go ahead and be implemented.
Mr. ETHERIDGE. Thank you. Thank you, Mr. Chairman, for your indulgence.
Mr. EWING. Thank you, Mr. Etheridge.
Mr. SMITH. Thank you, Mr. Chairman, and thank you for moving ahead with this difficult task for reauthorizing and make sure that we do the right things of balancing overzealous regulation with the opportunity of the exchanges to move ahead and compete in the world market. That survival and that competition I think is important for American business, American farmers.
Page 41 PREV PAGE TOP OF DOC But one particular interest and concern that I have is farmers in the United States to make sure that in this legislation that we continue to encourage and expand the opportunities of production agriculture to utilize these markets to minimize risk and maximize potential profits. We started this in 1936 for agriculture, for farmers, and for almost 40 years, it was controlled by the U.S. Department of Agriculture. Shortly after I went into the Department in 1970, a decision was made because of the expansion of the derivatives market because of more and more people utilizing the futures trading through the exchanges, it was moved in 1974, I think, out of Agriculture, and we started the oversight that has now become very significant.
I guess one question I have: Can anybody give me what percentage of the activity of the exchanges is related to agricultural commodities?
Mr. PAUL. Congressman, I believe it is 15 percent of the U.S. exchanges is for agricultural products.
Mr. SMITH. As I understand it, all the exchanges are for-profit businesses. Is that right? These are private corporations trying to maximize their profits for their investors and for their boards. Is that correct?
Mr. PAUL. You are far-sighted, Congressman. Right now the exchanges are in the process
Mr. SMITH. I only have one eye.
Mr. PAUL. of demutualizing. They are currently primarily member organizations not for profit. As we speak, a number of the exchanges have been taking votes in Chicago and other places that will turn them into a for-profit business. Currently the Kansas City Board of Trade is the only private corporation in this country.
Mr. SMITH. How does this compare with other countries? What is Europe doing? Are there not-for-profit exchanges in Europe?
Mr. PAUL. Yes. But this trend that we see of the demutualization is worldwide. In fact, I think the European exchanges have been somewhat a head of us in this area. And we see the same thing occurring on the security side as well. Ms. Nazareth can address that. But that seems to be the overwhelming trend, that exchanges worldwide have gone from nonprofit membership organizations to for-profit corporations.
Page 42 PREV PAGE TOP OF DOC Mr. SMITH. I am concerned with agriculture, of course, and the reason it is coming through this committee, as well as some of the jurisdictions of other committees in Congress, is because we started out doing it for agriculture and for farmers to offer for them the opportunity.
I guess I am concerned, Mr. Paul, certainly with the Securities and Exchange Commission but also with CFTC in terms of your efforts and oversight and interest being more expanded outside of agriculture with less interest and less concern for agriculture. Is that fair to say inasmuch as only 15 percent is concerned with ag commodities? And of that 15 percent, I suspect less than half are actual producers utilizing the exchanges.
Mr. PAUL. Congressman, the CFTC is very concerned with agriculture, particularly the producer community. In fact, the Commodity Exchange Act was developed as a result of manipulations of the agricultural markets. The whole raison d'etre for the CFTC was regulation of the agricultural markets, and following H.R. 4541, the agricultural markets will be perhaps more important than ever to this agency.
We take the need to protect the agricultural markets very seriously because it is a special category. Much of the proposal that we have published currently on regulatory relief on exchanges has certain carve-outs with respect to the agricultural products. For example, a few months ago we had proposed a rule change that would permit exchanges to automatically on their own change rules or adopt new rules without prior approval by the CFTC because the agricultural community expressed concern about that. In the current reform package, we have provided that rule change but with a carve-out for the agricultural contracts. That is because of the nature of the products. They are subject to manipulation at perhaps a much higher degree than most of the other commodities that we regulate, because of the market participants who are many of the Nation's farmers as well as the implications that the agricultural markets have on price discovery. They are the main source of price discovery for all of our agricultural products, and we recognize that the implications that that has on the U.S. economy is far-reaching beyond just those participants in the market. So, we are acutely aware of our responsibilities there and have no intention of relaxing those responsibilities.
Page 43 PREV PAGE TOP OF DOC Mr. SMITH. Thank you. I appreciate your response.
In terms of timeliness, if this bill were passed into law the 26th of August, how long would it take to implement and promulgate rules and regulations?
Mr. PAUL. That is a very difficult question, Congressman.
Mr. SMITH. Could you do it in a year?
Mr. PAUL. But based on the fact that everything is in play right now at the Commission with respect to our rules, we have undertaken, through our task force, to in essence go through the entire rule book and rewrite as much of it as possible over the last 7 months. I would say that this is probably the best time for us to be able to implement the types of rule changes that the bill proposes because, in fact, the bill is an attempt to codify what our regulatory relief proposal is in the first place.
So, to the extent that we can bring the current version of the bill in line with the current version of our rule proposal and as it plays out over the next 45 days of our comment period through public hearings and comments from the public, if the bill passed, I would think we could promulgate rules within a year.
Mr. SMITH. Mr. Chairman, thank you.
Mr. EWING. Thank you, Mr. Smith.
Mr. DOOLEY. Thank you, Mr. Chairman. I apologize I was not here to hear the oral testimony. I have had a chance to read the written testimony, though, and am struck by almost everyone who submitted testimony is commited to trying to find a way where we can resolve some of the remaining disagreements over how do we reform or repeal Shad-Johnson. I have heard many people respond in part to that.
I am a little bit still at a loss. If everyone is committed to doing this, what are the impediments to fixing this? What are the outstanding issues that are creating such difficulty in reaching an agreement on this? Because from an outsider, as I am looking at this, it looks like it is in some ways motivated by a little bit of a turf battle here, and that is not necessarily addressing the intent of this legislation in terms of ensuring that we are creating a system that is more efficient in responding to consumer and market interests.
Page 44 PREV PAGE TOP OF DOC Ms. NAZARETH. I can appreciate that question. I really do not believe that this is simply a turf battle. I think that there are significant challenges in being able to craft a framework that adequately protects investors in the manner that they have come to expect in the securities markets, of course, in this case the futures would be a surrogate for the securities. So, investors should expect the same level of protection that they currently enjoy on the securities side.
The Commission also has concerns with market integrity and market manipulation. So, being able to craft a framework that ensures that those interests are adequately covered and protected, while at the same time, as Mr. Paul previously suggested, not hamstringing the markets by excessive regulation that they actually would not be able to trade the products has really been our goal. So, the goal is to come up with a framework that we think works.
The Commission's view is that the way you do that is to define these products not only as futures but as securities to provide that the products are jointly regulated and then have the agencies determine what is core to their frameworks; what is essential in order to ensure that there is harmonization of the regulation across the markets and that the markets are not in any way impaired.
Mr. DOOLEY. I would not expect that the CFTC would say that the objectives and goals would be any different than what you just articulated. So, why are we having such difficulty addressing those issues? If we are looking at harmonizing the margin requirements, why do we not do it? I still at a little bit of a loss here. Mr. Paul, do you have a comment?
Mr. PAUL. I agree with you, Congressman. The CFTC would agree with practically all of the goals that Ms. Nazareth enunciated. Philosophically we are very close as to what we think the right level of market protection as far as the investors would be concerned.
Page 45 PREV PAGE TOP OF DOC I think the biggest problem, the biggest stumbling block, unfortunately, plays out with the legislation. It is how do we change the statutes to permit these products to be traded on futures and securities exchanges.
I also agree with Ms. Nazareth, certainly from the CFTC's standpoint, this is not a turf battle. I think that the agencies have been extremely enlightened in how they have come together and acknowledged reciprocal jurisdiction and shared jurisdiction in a way that is probably unparalleled for these agencies. For the first time we have a product that we no longer would have exclusive jurisdiction over trading on the futures exchanges. We recognize that there is an important need to have joint regulation. And going down to specifics of how that plays out, the SEC and the CFTC have agreed on many of the specifics over the last few months.
The problem arises in how do we change the statutes to allow these products in and to ensure that there is the appropriate level of regulation necessary by each of the agencies without overlap that would be too costly and anticompetitive for the exchanges and the intermediaries who trade the products.
Mr. EWING. Thank you, Mr. Dooley. I think you got to a very important there.
In a town that is very political and in a Congress that is divided by six votes, you see members of both parties here saying, get the job done, to the agencies. You know, it is hard for us to believe, with all the partisanship we deal with daily, that when we are together, the agencies cannot come up with the language to put in a bill. Does that seem strange to you?
Mr. MORAN. If that was a question for me, Mr. Chairman, it does seem strange. [Laughter.]
Mr. EWING. I knew it would.
Page 46 PREV PAGE TOP OF DOC Mr. MORAN. Mr. Chairman, thank you for your drive on this issue, this legislation, and your leadership on this and many issues in Congress will be missed by me and your colleagues on this committee, this subcommittee, and on the House floor come next session. As other members of the committee have said, we appreciate what you are trying to accomplish here today.
A couple of questions, if I might. My understanding is that there is also a companion piece of legislation in the Senate, somewhat similar, perhaps reasonably similar to what we are working on this morning. One of the differences that has been apparent to me is where futures on securities are to be traded, and in this bill we allow those futures on securities to be traded only on the futures exchanges, whereas the Senate version of this legislation allows for trading to occur on futures options and securities exchanges. I wondered if you all had an explanation why one was better than the other.
Mr. PAUL. Well, Congressman, from the earliest stages of our discussions with the SEC, we had advocated that both types of exchanges should be able to trade these products. I agree with Ms. Nazareth's earlier comment that competition should determine the winners and losers, not the regulatory scheme, and we felt that it would be best for the customers and the participants in the markets and the exchanges themselves if we opened up a franchise for both types of exchanges to be able to trade these products.
We had discussed with the SEC, and made substantial headway, a regime whereby each of us would have primary jurisdiction over our currently registered exchanges, but that any exchange wishing to trade these products, because of the fact that they had substantial elements of both a future and a security, would be required, through a short-form notice registration, to register with the other regulatory, and thereby at least be subject to the enforcement authority and other regulatory authority that each of the regulators would have.
So, we believe that it is important to bring these products to market as soon as possible to allow them to trade, and we also think that it would be in the market's best interest to allow them to trade on as many exchanges as possible.
Page 47 PREV PAGE TOP OF DOC Ms. NAZARETH. I agree. I think we certainly agree that it is important that these products be able to trade competitively. I think we were perhaps assuming that element of this bill would be altered because the agencies certainly have always worked on the assumption that the products would trade on both options and futures exchanges.
Mr. MORAN. So, the goal would be to be traded in a more broad fashion than what the House bill provides.
Ms. NAZARETH. Yes.
Mr. MORAN. And there is no dispute between the two of you in the regulatory sense that creates an impediment toward that happening?
Ms. NAZARETH. Not at all.
Mr. PAUL. No. The only thing I want to clarify, though, is because we think it is in the best interest to trade these on both exchanges but we do not want to pick winners and losers by virtue of the current regulatory structure, that is why it is important to us that we try to tailor those provisions of the securities statutes that would apply to the futures exchanges so as not to give an unfair advantage to the securities exchanges that are already subject to the SEC jurisdiction and already comply in full with the full panoply of those acts, as opposed to the futures exchanges which may have to build up what they currently do to address the specific SEC concerns on trading of single stock futures.
Mr. MORAN. So, the outcome and your deliberations over regulatory issues has an impact upon which exchanges these instruments would be traded. You have got to reach a conclusion on the regulatory issues for this to traded broadly.
Mr. PAUL. That is correct, but we do think that they should be traded on both types of exchanges.
Mr. MORAN. Is the regulatory scheme such that there will be shopping for who the regulator will be between well, are the regulations for brokers and dealers under the Government Securities Act the same under the Commodity Exchange Act or is there a difference that would, therefore, cause there to be shopping for who is to be my regulator? This may be a Treasury issue.
Page 48 PREV PAGE TOP OF DOC Mr. SACHS. I think, Congressman, some of that is a Treasury issue. And, yes, under current law, there are differences in how instruments that are related to Government securities are regulated, whether they are traded on a futures exchange or elsewhere. Those differences to date are not substantial enough to cause a great deal of concern on behalf of the Treasury.
My remarks, to which I believe you are referring which are in my prepared testimony, have to do with a specific provision in this bill that would substantially alter that balance. We do not see the need for there to be perfect symmetry in how they are addressed in the futures world and how they are addressed elsewhere, but the gap that would open up under the provisions in this bill related to what are called exempt boards of trade would cause that to fall so far out of balance that we do believe there is a potential for substantial regulatory arbitrage and that that could cause some problems in the market for Government securities.
Mr. MORAN. Could you explain to me why the provision that you are concerned about is in the bill, what purpose it serves?
Mr. SACHS. Honestly, Congressman, I do not know how it got in there in the first place. I believe it was picked up in an early draft of the reg relief proposal that the CFTC released in February. We are in ongoing discussions with the CFTC on this particular issue and we will be commenting in a formal comment letter during the comment period that is open for the next month or so. We will be sending something over to them and will be happy to share it with you in the next few weeks.
Mr. MORAN. I was trying to figure out whether the benefits of this provision outweigh the concerns that you raise in regard to regulatory arbitrage and look forward to your future comments.
Mr. Chairman, thank you very much.
Mr. EWING. Mr. Walden.
Page 49 PREV PAGE TOP OF DOC Mr. WALDEN. Thank you, Mr. Chairman.
Now, Mr. Parkinson, I have a question for you. Your testimony states that the Board will be willing to accept regulatory authority over the level of margin on single stock futures as provided for in the bill as long as the Board can delegate that authority to the CFTC, the SEC, or the intermarket margin board consisting of those three agencies. The Board also notes that margin levels on futures and options should be considered consistent, even if they are not identical. Would you be able to harmonize margin between futures and options?
Mr. PARKINSON. Yes, I think they are capable of being harmonized in the sense that we laid out in the testimony. In fact, these are issues that have been debated before. The language that is in our testimony really is drawn from the President's Working Group's very first report back in 1988, when there was a very intense focus on the consistency of margins between cash markets, futures, and index options. I think there was an understanding reached at that time how to think about these issues. The key thing is that similar methodologies be adopted.
Actually, at the level of clearing members and market professionals, for stock index futures today the margining systems in the options markets and the futures markets already have been harmonized. They are used in cross-margining programs and both the CFTC and the SEC, as I understand it, are comfortable that the methodologies, which differ in terms of the technical details, provide equivalent coverage. That was one thing that they had to be satisfied of before they would let the cross-margining programs go forward.
So, I do not think this is an insurmountable issue by any means.
Mr. WALDEN. I want to kind of follow up on the theme Mr. Dooley had raised because I was thinking the same. Maybe I am the only one on the committee that feels this is a highly technical and difficult issue to swallow. But it seems to me that you all have made considerable progress on the first two points, and indeed there seems to be pretty much agreement. There may be some technical issues in the drafting of the legislation we need to take another look at.
Page 50 PREV PAGE TOP OF DOC But on this third issue, I understand you are in agreement on goals and theory. Can you eventually provide for us the very specific detailed parts of the code where you disagree? Because the theory is not going to help us. We all want to protect the people in the markets. We all want to make sure the right regulatory framework is there. But at some point you must leave these hearings and go sit in your own offices and say, I can never swallow this or I can never agree to that. Those are, I think, the nut of it. What are those issues very specifically? I am not necessarily asking you to do that right now.
But if we are going to end up having to make the decision, we need to know what those specific issues are and then what the up sides and down sides of those are. I know, to an extent, you have got that in your draft proposal and all. But I would love to have that debate sometime if we are going to end up being the ones making the decision for you.
Thank you, Mr. Chairman.
Mr. EWING. Thank you, Mr. Walden.
Mr. THUNE. Thank you, Mr. Chairman. I want to thank you and your staff for the effort that you have made in trying to fashion something that will address most of the issues that I think most of the people in this room want to see resolved in moving this forward. I would also say to my friend from Oregon that he was thinking along the same lines I was, and because the subject tends to be a little complex, either he has got a tremendous amount of brilliance or he is totally in the dark like I am. I am not sure which it is.
But this is an issue which is very complex and one which demands a good amount of study and deliberation and I think that the effort that has been made on behalf of the staff and the folks in this room who have contributed to the product that we have in front of us today is a very worthwhile effort, and hopefully we will be able to get something done in this session of Congress. It seems to me at least that there is a range of issues on which there is agreement.
Page 51 PREV PAGE TOP OF DOC I guess I would maybe harken back and I do not know how much this has been hit on already, but just ask the panel what would be, if any, the impact on an average producer. Originally when these exchanges and so forth were created, it was trading agricultural commodities. There is a great deal of apprehension out there about how they have evolved into something sort of other than that. I am wondering if, in fact, you see any impact on the average whether it is someone who is raising hogs in the Midwest or anywhere else in the country. Are there any of these changes that will in any way change the way that they operate in terms of trying to hedge and whatnot?
Mr. PAUL. The CFTC believes that it is important to provide a regulatory framework which we think that your bill helps to encourage development of innovation, technology, new products in the markets, which benefits all market participants, including the agricultural producers, including the hog farmer as well as the grain grower. In fact, recently we approved an application for an agricultural electronic exchange futures.com which will be starting business we expect later this year. We think that all markets can benefit from innovation, progress, and technology, and that we need to provide the ability for the innovators to take full advantage of the improved technology and other aspects that make trading easier to do for a greater number of people.
Now, we recognize that, with those changes, it presents lots of other issues with the increase of trading over the Internet. The, perhaps, greater access of retail customers to not types of markets that have not been involved in before might require greater vigilance. But we think that that is not a reason not to permit it to happen. We think that we can try to stay ahead of the learning curve and we want to make sure that we do not have anticipatory regulation that would impede the development of those things. We think that that benefits every segment of the market.
As I said earlier, though, we recognize that the agricultural markets require perhaps a greater level of protection than some of these other markets, certainly more so than the financial markets. And we take that into account with our own regulatory changes as well as in our comments on proposed legislation.
Page 52 PREV PAGE TOP OF DOC Mr. THUNE. Is the SEC on the issue of Shad-Johnson and the question of margin harmonization and suitability sort of isolated? You talked about differences and where the agreement is on the issues that are in the draft. Legal certainty and those issues everybody agrees need to be addressed. I am just wondering. Again coming back to Mr. Walden's question about the areas of differences and how we resolve those, there has been a period, a long period, in which to study the issue and how we fix it, and I think the bill allows for another year in which to figure out a way to implement single stock futures. But I am just wondering on the panel, is that a view that is unique to the SEC where it comes to Shad-Johnson, or is that a concern that others share as well?
Mr. SACHS. Congressman, with respect to Shad-Johnson broadly, we have not taken a position any different than that which we articulated in the working group report and I stated in my open testimony and actually have not gotten into the level of detail as the CFTC and the SEC have in their discussions with respect to each individual provision of each of the acts. We feel strongly, as I said earlier, that the provisions in the Shad-Johnson Accord that preclude trading of single stock futures can be repealed. I do not know if it is fair to say the SEC is isolated in their concerns. I think that many of us share some of those concerns, but we do feel that they are resolvable and should be resolvable hopefully in the near term.
Mr. PARKINSON. Again, we are hoping this can be worked out. I think we might have some more sympathy for the bottom up than the top down approach, but I accept the SEC's point that it is not a matter so import where you start as to where you come out. Presumably, whichever you take, the issue is what are the provisions in the securities laws that should apply to trading on a futures exchange, and that is what needs to be focused on.
On the one issue of margin, I think it would be our view that that should not be a stumbling block. We are willing to play the role the committee has outlined, and I think there is a way to make these margin requirements consistent.
Page 53 PREV PAGE TOP OF DOC With regard to the broader range of issues, we have not taken a position on how to resolve those, which provisions should apply, which provisions should not apply.
Mr. SACHS. Congressman, if I could just add. On the question of margin requirements, since I did touch on it in my prepared remarks, while we do feel that that is one of the important issues with respect to Shad-Johnson, we do not think it is necessary to resolve exactly how margin would be established in order for this legislation to move forward. That is something that can be addressed by the regulatory agencies and the rest of us down the road. While we feel strongly that it is quite important and that it does need to be addressed and it should not lead to regulatory arbitrage or to a substantial increase in leverage in the financial system, it is not necessary to resolve exactly how that is done in this legislation.
Mr. THUNE. Does the SEC care to comment or not?
Ms. NAZARETH. I agree with that statement. I agree that we do not need to resolve what are the magic numbers here today. I think what we are interested in ensuring is that there is a mechanism going forward so that we not only have harmonized margins at the time the legislation is passed, but also that there is a mechanism in place for ensuring that over time, as those margin levels change in the futures markets, that they are also changed in a consistent manner across the markets.
Mr. THUNE. Well, I just, as this moves forward, hope that we can get an agreement, and differences of opinion that are based upon I think it was alluded to earlier jurisdictional issues I hope we can get over. I understand there are some substantive type differences as well, but I guess my view would be that there is an adequate level of safety and protection there, but also we want to modernize the framework in a way that works for everybody who is a party to transactions that occur in these markets. It is, I think, desperately in need of that modernization. So, hopefully we can move forward with some legislation this year.
Again, I appreciate the work that the chairman has done in doing this, and we will certainly miss his leadership next year. I hope we can get this issue resolved and something enacted before you leave.
Page 54 PREV PAGE TOP OF DOC I yield back.
Mr. EWING. Thank you, Mr. Thune.
A couple of wrap-up questions, and we may also be sending you some written questions.
We have talked a lot about single stock futures and the Shad-Johnson. Isn't that really kind of being done now in other ways besides straightforward single stock futures on the exchange? We do not do that. We do options. There are other ways that maybe this Shad-Johnson rule could be circumvented with Internet trading. Isn't this, in fact, happening or very likely to happen here in the United States in the near future?
Ms. NAZARETH. I believe what is happening today is subject to full SEC regulation, that our markets are fully covered within the regulatory framework, and that retail investors are fully protected today under that framework. So, that is really the heart of the issue, whether similar activities can go forward in a manner that consistent and subject to the same protections that comparable transactions are subject to today.
Mr. EWING. Do any of the rest of you have any comments in that regard?
Mr. PAUL. Well, Mr. Chairman, you are right. Not only can you do similar kinds of trading through option positions, but the fact remains that single stock futures are being offered and traded in other markets around the world and that U.S. investors are denied the opportunity to do that. We think it is important that we move forward as quickly as possible. The markets tell us that they want the product. The exchanges tell us that they would like to offer the product. We think, with that working out with the SEC an appropriate approach, we should try to use every resource at our availability to try to offer these products as soon as possible so as not to put our exchanges at a competitive disadvantage.
Mr. EWING. Well, you went to the second part of my question, which was, if we are not doing it a roundabout way here, they are doing it on foreign exchanges.
Page 55 PREV PAGE TOP OF DOC Mr. PAUL. Correct.
Mr. EWING. Those are open to American investors if they care to use them. That is a question. Not necessarily?
Ms. NAZARETH. Well, they cannot directly access U.S. investors. U.S. investors would have to go find them. They would be subject to U.S. jurisdiction if they solicited U.S. transactions. So, they really are not.
Mr. EWING. But the sophisticated trader in this country or maybe some that are not so sophisticated could find their way to using those markets. They may not be able to set up shop here in the United States, but in the world economy and the world as we know it today, I would think that information and that availability would be made available to investors in this country.
Ms. NAZARETH. Well, technically they also are not offering those products on U.S. securities. So, they could engage in those transactions but they would not be single stock futures on U.S. stocks.
Mr. PAUL. And Ms. Nazareth is correct. The problem, though, is if you do have a U.S. investor trading on one of these foreign markets, while technically they should not be permitted to, whether or not the SEC or the CFTC could effectively enforce that prohibition is a whole other issue. I think that that is what your question was driving at.
Mr. EWING. Well, it was.
The other point is, Ms. Nazareth, how do you define a U.S. security?
Ms. NAZARETH. A security that is registered with the Securities and Exchange Commission.
Mr. EWING. But I mean, we trade many foreign securities on our exchanges. Is that correct?
Ms. NAZARETH. But they are subject to U.S. regulation and, if they trade on a U.S. securities exchange, they are registered in the United States.
Page 56 PREV PAGE TOP OF DOC Mr. EWING. I understand that, but I meant there are many securities which are available here that are also registered here, but they are not really U.S. securities. They are foreign companies.
Ms. NAZARETH. Yes.
Mr. EWING. So, those would be available on foreign stock exchanges or foreign exchanges.
Mr. PAUL. That is correct. Some of them would be.
Mr. EWING. Some of them would be. I guess I am having a hard time making the point, and you could all be more cooperative with me. [Laughter.]
The competitiveness out there and what is available to investors we want to protect our investors, but we also know they have other places to go, and we would like to keep our exchanges and our financial markets the best in the world.
One final question. Is it your opinion that it was the intention of the President's Working Group, when it submitted its report to Congress last November, that over-the-counter derivatives excluded from the Commodity Exchange Act be free to be regulated by the Securities and Exchange Commission or other Federal regulatory agencies?
Mr. SACHS. Mr. Chairman, I do not recall the exact words we used in the report. We did reference this issue I believe early in the President's Working Group report and we stated that just because these instruments are excluded from the Commodity Exchange Act under the working group framework, it did not mean to suggest that other statutes on some of those instruments would not apply. We did not specify what would or what would not. We actually did not do an exhaustive study of what the other statutes might be.
We also did not mean to say specifically that any statute would apply, but we did reference it in the report and we said that excluding these from the Commodity Exchange Act could potentially lead to that.
Page 57 PREV PAGE TOP OF DOC Mr. PARKINSON. I would say, if you are asking are swaps securities or should swaps be regulated as securities, the report was silent on those questions. It did not express a view one way or the other.
Mr. SACHS. I would agree with that.
Ms. NAZARETH. The focus of the report was whether or not swaps should be excluded from the Commodity Exchange Act, so the study did not go to whether there were other regulatory agencies that had jurisdiction over those products. It is certainly the SEC's position that some swaps are securities, and to the extent that they are securities, the Securities and Exchange Commission has jurisdiction over those products.
Mr. PAUL. Speaking on behalf of Chairman Rainer, his agreement to the recommendation of the President's Working Group I think in part contemplated that an exclusion from the act was to provide legal certainty to the OTC derivatives markets with respect to regulation under a U.S. regulatory and statutory scheme and that it was not necessarily just to remove the CFTC as an impediment, but to open up the door for another regulator.
Mr. EWING. And not to open up the door?
Mr. PAUL. Not necessarily, correct.
Mr. EWING. It was to provide legal certainty.
Mr. PAUL. Legal certainty to the over-the-counter markets.
Mr. EWING. To follow up on that, legal certainty would be defined as those dealing in those securities to know what their obligations are.
Mr. PAUL. Correct.
Ms. NAZARETH. I believe legal certainty was intended to ensure that when counterparties entered into a transaction, there was not a risk that those transactions would be deemed voidable. And that was the implication of the transactions being subsumed under the Commodity Exchange Act. That is why the working group focused specifically on whether those swaps should be excluded from the Commodity Exchange Act.
Page 58 PREV PAGE TOP OF DOC Mr. EWING. But wouldn't the legal certainty also need to require that there be legal certainty that they are not voidable under the SEC regulations
Ms. NAZARETH. I can say with certainty today that they are not voidable. So, there is no issue of legal certainty with respect to the application of the securities laws.
Mr. EWING. We do not want to cloud that legal certainty that we have all agreed on here.
Mr. PARKINSON. I would just add I think Ms. Nazareth is correct. If you ask the question why have we not been addressing the questions are swaps securities or should they be regulated by securities, number one and most importantly, there is no legal uncertainty issue. No. 2, the SEC has been cautious, I would have to say, in asserting jurisdiction in this area. They have not, for example, issued a concept release about regulating swaps under the securities laws.
Having said that, again to agree with something Bob said, by excluding OTC products from the CEA, we certainly were not inviting the SEC to abandon its cautious position and begin regulating assertively in this area.
Mr. EWING. Any other comments?
Mr. EWING. I again thank you very much. I think this has been a very useful hearing, and you have been very cooperative with your time and very candid with your answers. If there are no further questions, I would like to thank you for your time.
The record will remain open for 10 days to accept statements and any other additional information.
This hearing is adjourned.
Page 59 PREV PAGE TOP OF DOC [Whereupon, at 12:12 p.m., the subcommittee was adjourned; subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
Testimony of C. Robert Paul
Thank you, Chairman Ewing and members of the subcommitteee. I am pleased to be here to testify before you on behalf of the Commodity Futures Trading Commission, and I appreciate the opportunity to discuss the important issues addressed in H.R. 4541.
First, the Commission commends Chairman Ewing on his efforts to modernize the Commodity Exchange Act and to act on the recommendations of the President's Working Group that were designed to provide legal certainty for over-the-counter derivatives, remove impediments to innovation and reduce systemic risk. Consistent with its stated goals, the Working Group encouraged the development of electronic trading systems and appropriately-regulated clearing systems for OTC derivatives.
The Working Group also stressed the urgency of implementing its recommendations to maintain U.S. leadership in these rapidly developing markets. Such timely implementation is essential to enable U.S. markets to keep pace with the technological changes occurring in markets around the world. A critical element of this process is reform of the Commodity Exchange Act. The Commission recognizes the challenges involved in such an undertaking and appreciates Chairman Ewing's thoughtful and comprehensive approach to this complex task as well as the subcommitteee's strong push to advance the reauthorization process this year.
The Commission welcomes Chairman Ewing's proposal to enhance legal certainty for over-the-counter derivatives by excluding from the CEA certain bilateral transactions entered into on a principal-to-principal basis by eligible parties, as recommended by the Working Group. The market for OTC derivatives has expanded dramatically over the past two decades. The vast majority of OTC derivatives are interest rate and foreign exchange contracts, and the markets are comprised almost entirely of institutional participants.
Page 60 PREV PAGE TOP OF DOC These large and sophisticated markets play an important role in the global economy, and legal certainty is a crucial consideration when parties to OTC derivative contracts decide with whom and where to conduct their business. Therefore, the President's Working Group recognized that legal certainty for OTC derivatives is vital to the continued competitiveness of U.S. markets. We believe that H.R. 4541 would help achieve legal certainty by excluding these transactions from the CEA.
The members of the Working Group agreed that electronic trading systems have the potential to promote efficiency and transparency. The Working Group concluded that such systems should be permitted to develop unburdened by an anticipatory regulatory structure that could prove inappropriate over time. It is critically important that we allow our markets to exploit new technologies without undue regulatory constraints if they are to remain competitive with foreign markets. The Commission believes that H.R. 4541's statutory exclusion for electronic trading facilities will advance the goal of providing the necessary legal certainty envisioned by the Working Group and will create an environment in which innovative systems can be developed and implemented.
H.R. 4541 would also permit clearing of OTC derivatives and would create a mechanism for the CFTC to regulate facilities that clear OTC derivative contracts. Again, the President's Working Group specifically recommended removing legal obstacles to the development of appropriately-regulated clearing systems to reduce systemic risk. We support this recommendation and look forward to working with Congress, with other Federal regulators, and with the industry to develop a system of clearing financial market transactions that will allow for improved risk management and enhanced stability of the OTC derivatives markets. The CFTC hopes that these statutory changes will lead to a dialog that will achieve the maximum level of reciprocity among financial regulators for the clearing organizations under their respective jurisdictions.
Consistent with the Working Group's recommendations, H.R. 4541 also redrafts the Treasury Amendment to make clear that the Commission has jurisdiction over transactions entered into between retail customers and unregulated entities. This provision clarifies the Commission's jurisdiction over so-called ''bucket shops'' and strengthens the Commission's ability to take enforcement action with respect to retail fraud and other unfair practices in the foreign currency market. We endorse the provisions of the bill designed to protect retail customers, provide legal clarity, and reduce litigation over jurisdictional issues in this area.
Page 61 PREV PAGE TOP OF DOC In addition, H.R. 4541 would codify an exemption from most provisions of the Commodity Exchange Act for transactions in energy and metal commodities. This is one area in which H.R. 4541 diverges from the recommendations of the President's Working Group, and the Commission believes that these provisions raise concerns that have yet to be resolved.
The Commission notes that exemptions for metal and energy commodities, particularly as they relate to electronic trading systems that approximate exchange environments, are not governed by the same considerations that formed the basis of the Working Group's recommendations with respect to financial products.
While there are some similarities between the trading of financial products and non-financial products, there are also significant differences. For example, the Working Group, in recommending an exclusion from the CEA for financial derivatives, noted that ''most of the dealers in the swaps market are either affiliated with broker-dealers or FCMs that are regulated by the SEC or the CFTC or are financial institutions that are subject to supervision by bank regulatory agencies. Accordingly, the activities of most derivatives dealers are already subject to direct or indirect Federal oversight.'' (PWG at 16, emphasis added). The same cannot be said for trading in energy or metal derivatives. Also, as with agricultural commodities, the prices set on regulated exchanges for products such as copper, crude oil or home-heating oil have significance beyond the participants in those markets.
The CFTC has already exempted many types of energy trading from the provisions of the Commodity Exchange Act. But the exemption for energy commodities included in H.R. 4541 expands the scope of the Commission's existing exemptions for such contracts. The Commission's 1993 energy exemption is limited to those parties with the capacity to make or take delivery, but H.R. 4541 would extend the exemption to encompass eligible contract participants as defined in the bill, not just those acting in a commercial capacity. The 1993 energy exemption is also limited to transactions in which the material economic terms are subject to negotiation and that are prohibited from being cleared. H.R. 4541 specifically permits clearing and contains no limits on standardization of contract terms. In essence, unlike the Commission's current energy exemption, H.R. 4541 envisions exempting transactions that mimic those that are conducted in a traditional exchange environment. It is this multilateral trading aspect of the proposed statutory exemption that concerns the Commission.
Page 62 PREV PAGE TOP OF DOC The Commission recognizes that the proposed exemption is still subject to Sections 5b, 12(e)(2)(B), 4b, 4n, 4c(b), 6(c), 9(a)(2) and to such transparency rules or regulations as the Commission may impose. We support the retention of these sections, including the Commission's antifraud, antimanipulation, and preemption authority, and we support the authority to promulgate rules or regulations relating to transparency requirements. In addition, we recommend the Commission be given the authority to promulgate rules and regulations pursuant to the specified sections of the Act. In providing the Commission with the responsibility to police for fraud and manipulation, that responsibility can best be carried out if the Commission is also granted the concomitant authority to promulgate appropriate regulations.
In the Commission's experience, prices on certain metals have been manipulated, and we believe that futures and option transactions in these commodities require full regulatory oversight by the CFTC to protect the markets and their participants from unlawful practices. The Commission believes that, in developing an appropriate regulatory scheme, it would be appropriate to review contracts on a case-by-case basis utilizing the criteria set forth in our regulatory reform package, which considers risk of manipulation, the degree to which a contract serves a price discovery function, and characteristics of the market participants. As the discussion over the treatment of energy and metal commodities progresses, the Commission will continue to work with the Chairman and members of the subcommitteee to find an acceptable resolution of this issue.
On February 22, 2000, a staff task force of the Commission proposed far-reaching and fundamental changes to modernize Federal regulation of futures and options markets. This proposal was based on a comprehensive evaluation of the Commission's current regulatory structure and represents an effort to streamline that structure and to relieve domestic exchanges from unnecessary regulatory requirements. In drafting the proposal, the staff also followed the Congressional directive to transform the Commission from a front-line to an oversight regulator, and we believe that the proposal is in accord with that directive.
Page 63 PREV PAGE TOP OF DOC Since February, the Commission has continued to work with other Federal regulators, the exchanges, and market participants to gather information and refine the proposal. Last week, the Commission approved the proposed regulatory reform package for publication in the Federal Register and announced that it will hold two public hearings on the proposal. We look forward to working with interested parties as we continue to tailor our regulatory reform proposal in a way that most effectively achieves the goals described above.
H.R. 4541 attempts to codify much of the Commission's regulatory reform proposal, and we welcome Chairman Ewing's support of the Commission's initiative to revamp the way in which it approaches market regulation by providing a form and degree of regulatory oversight that is appropriate to the needs of the markets and their participants. While CFTC staff have provided extensive comments to subcommitteee staff during the drafting phase of the legislation, the agency's staff is currently undertaking a comparative analysis of our proposed framework, as released on June 8, and the relevant provisions of the legislation. We will shortly provide to the subcommitteee a detailed comment letter with the results of that effort.
As a general matter, however, we have identified some of the issues of concern to the Commission in this area. The Commission is concerned that the bill's negotiated enforcement provisions could weaken our enforcement authority. With respect to the more technical aspects of the regulatory reform proposal, it appears that the rules relating to a derivatives transaction execution facility under the legislation would be less flexible and more restrictive than those proposed by the Commission. In addition, H.R. 4541 does not specifically enumerate those commodities that would be eligible to trade subject to less regulation or none at all; the Commission believes that such specificity would provide greater clarity for the marketplace.
Lastly, H.R. 4541 addresses the issue of equity futures contracts and reflects Chairman Ewing's efforts to develop a plan to amend the Shad/Johnson Accord. The Working Group recommended that the CFTC and the SEC work together to determine whether and how the Accord should be amended, and the agencies have worked diligently on this project over the last several months. We agree in principle that equity futures should be available to the marketplace. On March 2, we presented to Congress our areas of agreement and issues that remained unresolved up to that point in time, and on May 23, Chairman Rainer and Chairman Levitt met with Senators Lugar and Gramm to discuss the issue further. Although the agency staffs have agreed on many specific areas involving implementation of lifting the ban, we acknowledge fundamental disagreement concerning the appropriate legislative approach.
Page 64 PREV PAGE TOP OF DOC With respect to regulatory issues relating to futures regulation of single stock futures products, we do not object to the Shad/Johnson provisions of H.R. 4541.
Again, the Commission appreciates the opportunity to offer our views, and I would be happy to answer any questions that the members of the subcommittee may have.
Testimony of Annette L. Nazareth
Chairman Ewing and members of the subcommittee: I am pleased to appear today to testify on behalf of the Securities and Exchange Commission as you consider H.R. 4541, the Commodity Futures Modernization Act of 2000.
My testimony addresses two topics of significant interest to the Commission. First, the Commission reiterates its strong support for implementation of the recommendations by the President's Working Group on Financial Markets related to legal certainty for over-the-counter derivatives markets. Second, I will address the investor protection and market integrity issues raised by single stock and narrow-based stock index futures, the Commission staff's suggested approach to address these issues, and why we believe H.R. 4541 fails to address our concerns.
I. LEGAL CERTAINTY FOR OTC DERIVATIVES MARKETS
As you know, last year the Working Group issued a report on OTC Derivatives Markets and the Commodity Exchange Act (OTC Derivatives Report). That Report contained several recommendations related to legal certainty for OTC derivatives products. Given the critical role that these products play in our capital markets, I can think of few more important issues for Congressional consideration.
OTC derivatives markets are enormous in size because these contracts are critical to risk management for a vast array of businesses. In studying these markets, the Working Group's task was fairly narrowto determine whether the Commodity Exchange Act provided an appropriate regulatory framework for these markets. The Working Group unanimously concluded that for certain OTC derivatives the CEA was not the appropriate framework and that steps needed to be taken to ensure that the CEA did not stifle the natural development of these markets. For a more detailed discussion of the Working Group's recommendations, I refer you to my earlier testimony.
Page 65 PREV PAGE TOP OF DOC One cannot understate the historic significance of the consensus achieved by the Working Group. Four of the leading U.S. financial regulators unanimously agreed that the Report's recommendations, which reflected their combined regulatory expertise, urgently required implementation. The Commission is very supportive of this Subcommittee's efforts to further the goals of the Working Group. Moreover, as we have stated in the past, it is not necessary to link resolution of all issues raised in the bill to pass the much needed provisions on legal certainty for OTC derivatives.
H.R. 4541, as introduced, differs from the Working Group's recommendations in a few key respects. In particular, the Working Group recommended that certain OTC derivativesproducts which typically have not attracted retail investorsbe excluded from the CEA, provided that, among other things, they are entered into by sophisticated investors on a principal-to-principal basis. By contrast, the bill contemplates that certain agency transactions in OTC derivatives be excluded from the CEA. In addition, the definition of ''eligible contract participant'' in the bill would allow individuals that the Working Group did not consider to be sophisticated investors to enter into OTC derivatives transactions excluded from the CEA. Specifically, we do not believe that adequate consideration has been given to whether $10 million in total assets is a sufficient indication of sophistication for an individual investor. Moreover, the bill grants the CFTC broad discretion to declare anyone an eligible contract participant.
In addition, recognizing the significance of clearing systems to the management of systemic risk, the Working Group Report sought to clarify the regulation of clearing systems used for OTC derivatives. The bill does not adopt the Working Group recommendations on this issue, but rather introduces a notion of voluntary registration of clearing systems. Nor does the bill sufficiently clarify, as contemplated by the Working Group's Report, that the clearance of an OTC derivatives transaction by clearing agencies regulated by other financial authorities, such as the SEC, will not trigger CFTC jurisdiction over the transaction.
Page 66 PREV PAGE TOP OF DOC Finally, in creating new types of deregulated futures facilities, the bill would attach exclusive CFTC jurisdiction over products traded on these facilities. Such products might include physically settled futures on government securities and other financial instruments. The Commission does not believe that there is a justification for eliminating the traditional role of other regulators including the SEC in regulating the markets and intermediaries that trade such government securities and other products, especially when these products would be traded on facilities subject to even fewer investor protections than exist today on futures exchanges.
The Commission continues to strongly support the implementation of the Working Group's recommendations which are designed to provide legal certainty for the OTC derivatives markets. Those recommendations should be implemented immediately. We appreciate the efforts of this Subcommittee in furtherance of this goal, and we are committed to working with you as modifications are made to this bill.
II. LIFTING THE BAN ON SINGLE STOCK FUTURES
This year the Commission devoted tremendous staff resources to designing a legislative framework under which single stock and narrow-based stock index futures could trade. Disparities between futures and securities regulation, as well as the ease with which single stock futures were expected to substitute for securities, made this a difficult task. However, the Commission strongly believes that these products could trade if certain regulatory issues are resolved. More importantly, I believe these issues are resolvable.
Our efforts in this area have not been undertaken alone. In its OTC Derivatives Report, the Working Group identified several issues that would need to be addressed before trading of single stock futures can begin. Furthermore, the Working Group noted that these issues were best resolved by the Commission and the CFTC. Others, including this Subcommittee, also urged the SEC and CFTC to examine single stock futures. Accordingly, in pursuit of a resolution of these issues, the staffs of the CFTC and the SEC engaged in extensive discussions on this topic.
Page 67 PREV PAGE TOP OF DOC Although we were not able to craft joint legislation in this short period of time, we did reach agreement on fundamental principles for creating a framework for single stock futures. You will recall that Chairman Rainer and Chairman Levitt relayed these principles to you in a letter dated March 2. Letter from the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC, to the Honorable Larry Combest, Chairman, House of Representatives Committee on Agriculture, the Honorable Tom Bliley, Chairman, House of Representatives Committee on Commerce, the Honorable Tom Ewing, Chairman, Subcommittee on Risk Management, Research, and Specialty Crops, House of Representatives Committee on Agriculture, and the Honorable Charles Stenholm, Ranking Member, House of Representatives Committee on Agriculture (March 2, 2000).
Most important among these principles was that, given the legitimate regulatory interests of both the SEC and CFTC in these products, single stock futures should be subject to joint regulation by both agencies. The significance of this agreement should not be understated. It reflects movement towards truly modern financial regulationregulation that recognizes the interrelation between markets for different financial instruments and the need for all agencies with expertise and legitimate regulatory interests in a product to participate in that product's regulation. This is a positive step forward from outdated notions of exclusive jurisdiction and the view that because a product can be considered a ''future'' it should be solely regulated by the CFTC. I believe these agreements by our two agencies are significant, and I appreciate the efforts by the CFTC staff in working to reach them.
A. REQUIREMENTS FOR A LEGISLATIVE FRAMEWORK
1. General Principles for Markets that are Competitive, Fair, and Free From Fraud and Manipulation
The process of working through important issues with the CFTC led the Commission staff to identify minimum requirements for any legislation that permits the trading of single stock futures. Contrary to what some have suggested, this is not simply a turf battle between the futures and options markets and the agencies that regulate them. There are fundamental issues of market integrity and investor protection at stake. For this reason, we should move forward in a reasoned and principled manner, as we consider how to permit an entirely new product to trade. I think it would be useful to review the components we believe are critical for any legislative framework.
Page 68 PREV PAGE TOP OF DOC Shared Jurisdiction. First, single stock futures are undeniably a substitute for stocks and stock options, and are fully expected to be a retail product. Thus, the framework must recognize the legitimate interests of both the SEC and the CFTC in regulating these products. Single stock futures possess attributes of both securities and futures contracts. The nature of single stock futures makes joint regulation appropriate, and exclusive jurisdiction ill-advised. Shared jurisdiction and joint regulation entail both recognizing each agency as best qualified to apply the key components of the laws it administers, and coordinating the agencies' efforts to ensure efficient market regulation that is not duplicative or overly burdensome.
Encourage Fair Competition. Second, the framework must encourage fair competition among markets. We do not want a framework that lets differences in regulation determine winners and losers. Any legislation should allow both securities and futures markets to enter the competitive fray, but should not give any type of market an artificial competitive advantage. For example, mechanisms must be put in place to harmonize the margin requirements across markets on an ongoing basis. Otherwise, the market with the more lenient margin requirements will have an artificial competitive edge. Competition should be based on better products, services, and pricesnot on regulatory differences.
The legislation also should require coordinated clearing of single stock futures. This would allow the multiple listing of the same single stock future product on multiple exchanges and promote price competition in ways that we have recently seen narrow spreads to the benefit of investors in the options markets. Coordinated clearing also makes it more viable for new markets to enter the competitive arena over time. Without coordinated clearing, new markets will not be able easily to offer the same products as competitors.
Of course, regulators themselves also must avoid burdensome duplication that would hinder efficient, competitive markets. Accordingly, any legislation, where appropriate, should carefully craft exemptions for regulated entities and provide for interagency coordination to achieve these goals.
Page 69 PREV PAGE TOP OF DOCPROTECT RETAIL INVESTORS.
Third, the framework must acknowledge that single stock futures will be retail products. While extremely complex derivative products might not attract retail customers, a simple future on a share of a blue chip stock or an interest in a pool of single stock futures is the type of product that is sure to do so. This especially is the case when the same sales force can offer customers the single stock future, the underlying blue chip stock, and pooled product that consists of either or both, which we believe will happen. Accordingly, legislation must maintain the SEC's ability to protect retail investors and to maintain integrity of the markets on which they trade. For this reason, the SEC should have clear and direct authority over the markets and market participants that trade single stock futures.
Direct access to audit trails, coordinated market surveillance, inspection authority, as well as suitability and customer protection regulation, are all necessary to the SEC's ability to effectively regulate and protect investors. The SEC should not be required to seek the permission of any other entity to protect investors. The SEC has over 65 years of experience and legal precedent in protecting the publicexpertise that should be carried over to equity substitutes such as single stock futures. Our securities markets are second to none because of the investor confidence that has flourished under this regulatory framework. It would be extremely unwise to move ahead with legislation that lacks the elements necessary to ensure the market integrity, suitability, and customer protections that investors have come to expect under the securities laws.
Do Not Harm Existing Markets. Fourth, the framework must avoid any harm to existing capital markets. In lifting the ban on single stock futures and reopening jurisdictional issues, legislative changes should not take away existing SEC authority over financial products. For instance, the Shad-Johnson Accord clarifies the SEC's jurisdiction over security options, and that jurisdiction should not be diminished in any way. Nor should legislation eliminate existing SEC functions related to evaluating products such as broad-based stock indexes for susceptibility to manipulation. Investors have strong expectations about the integrity of markets that the SEC regulates, and the resultant investor confidence fuels the success of those markets. Accordingly, legislation should not eliminate any existing SEC oversight of securities and related markets.
Page 70 PREV PAGE TOP OF DOC Moreover, we cannot allow market integrity issues in new markets to migrate to existing capital markets. Because problems in one market, at times, may be identified and understood only by reference to another market, legislation must provide for coordinated surveillance of all markets.
2. DISCUSSION DRAFT
The Commission staff prepared a discussion draft that incorporates these legislative goals into amendments to the Federal securities laws and the Commodity Exchange Act. Unfortunately, due to the brief time allowed, the CFTC has not had a chance to review or comment on our draft. We are setting out below a brief summary of the principal elements of that plana plan that presumes shared SEC and CFTC jurisdiction over these products.
First, this draft framework defines single and narrow-based stock index futures as securities. This triggers SEC oversight and the application of the securities laws. Then, having brought the markets and intermediaries that trade these products under the securities laws, we next focus on detailed regulatory relief for some of these intermediaries and markets as a means to avoid unnecessary or duplicative regulation.
For example, we exempt from registration those floor brokers on designated contract markets already registered with the CFTC. We also create a simple process of notice registration for certain markets and intermediaries already registered with the CFTC. And, such markets and intermediaries would only have to comply with securities law provisions that are considered ''core.'' We clearly exempt these markets and intermediaries from the numerous non-core provisions of the securities laws, where the CEA and CFTC regulation sufficiently addresses the same public policy concerns.
For the core provisions of the securities laws that would still apply to these entities, we provide innovative ways to relieve their regulatory burdens and to coordinate our regulatory efforts with the CFTC. For example, for many of the proposed rule changes that CFTC-regulated markets would submit to the SEC, we provided for immediate effectiveness of such changes and a limited scope of review. Where appropriate, in areas such as examinations, we recognize that the CFTC should be the lead regulator for such CFTC-regulated entities and limit our activities accordingly.
Page 71 PREV PAGE TOP OF DOC In addition to the detailed regulatory relief and coordination provisions, we provide minimum requirements to be incorporated into listing standards for these products. Such requirements, along with provisions related to coordinated clearing, are aimed at promoting market integrity and intermarket competition.
Finally, we incorporate these products into other relevant securities laws, such as the Securities Act of 1933 and the Investment Company Act.
Our discussion draft would achieve our goals of creating a new market for single stock and stock index futures that is competitive, fair, and free from fraud and manipulation. U.S. investors deserve nothing less. U.S. capital markets provide the lifeblood of American business and are the place where American families invest their hard-earned dollars with hopes of earning returns that will provide for everything from their children's educations to their retirements. We cannot afford to put these markets at risk.
B. Comparison to H.R. 4541. Crafting our plan was not easy. As a result, I appreciate the challenges that you faced in drafting your bill. Unfortunately, as written, the bill does not achieve the goals of the legislative framework previously outlined, and the Commission therefore could not support the legislation. Let me mention some of our general concerns with the bill.
First, rather than embracing shared jurisdiction and joint regulation of single stock futures, the bill would grant the CFTC exclusive jurisdiction over these products. Although the bill implicitly recognizes that single stock futures should be subject to certain securities laws and principles, any role for the SECthe expert in administering such laws and principlesis not fully realized. SEC authority is illusory. For example, the bill calls for SEC participation in certain matters. If the CFTC or futures market participants totally ignore the SEC views, however, the SEC's only recourse is to litigate the matter. We cannot support such an inefficient system of regulation by litigation in areas where the need to protect investors and the integrity of securities markets is so clear. The bill's intention to prevent any reading of an appropriate role for the SEC under the bill is made clear in an unusual rule of construction (in section 23 of the bill), which appears intentionally to limit SEC jurisdiction.
Page 72 PREV PAGE TOP OF DOC The bill also does not adequately harmonize securities and futures requirements related to single stock futures, in order to assure that single stock futures would not receive an artificial regulatory advantage over securities products with which they compete. This is particularly disconcerting in the area of margin, where the bill is, at best, ambiguous as to how, on a practical level, harmonized margin levels between securities and futures markets could efficiently be maintained. Markets should not compete for customers based on how much leverage they are allowed to provide those investors. Furthermore, it is unclear how securities exchanges might trade single stock futures under the bill. The bill also fails to provide for coordinated clearing that would allow for greater intermarket competition to the benefit of investors.
In addition, the bill fails to provide the Commission with the necessary authority to ensure the market integrity and customer protections that U.S. retail investors have come to expect for securities products. Although the bill provides that the SEC can enforce certain sections of the Securities Exchange Act of 1934 (Exchange Act) for limited purposes, these provisions are so circumscribed as to promote minimal levels of market integrity. section 10(b) of the Exchange Act, for instance, appears to apply only for the purposes of insider trading and frontrunning. We see no legitimate reason to preclude the Commission from prosecuting other frauds on U.S. investors involving single stock futures that would otherwise fall within section 10(b) of the Exchange Act. U.S. investors deserve the anti-fraud and other protections included in other sections of the securities laws that do not make the bill's short list.
Moreover, the bill fails to recognize that the SEC's program of investor protection is comprehensive. Enforcement actions coupled with inspections and the ability to promulgate new regulations, when necessary, are essential ingredients of ensuring the integrity of America's markets. Although the SEC actively pursues those who violate the securities laws, much of our success results from the violations that are prevented before a single investor is harmed.
Page 73 PREV PAGE TOP OF DOC Another example of where the bill recognizes the need for securities law principles for single stock futures, but does not adequately implement those principles, is in the area of recommendations to customers and suitability. The bill calls for the promulgation of rules governing recommendations by intermediaries to their customers, and contemplates that the SEC would be consulted about how those rules are formulated. The bill, however, provides neither clear standards for those rules' content nor a mechanism to insure that these rules are truly harmonized with the well-developed suitability rules that apply to securities products today. For example, the bill could permit rules under which a salesperson could recommend a single stock future to a customer, even though suitability rules under the securities laws would preclude a recommendation to purchase the underlying security.
Similarly, investors rely on the Commission to protect them from unscrupulous, or even just sloppy practices, by investment advisers and mutual fund managers. The bill would introduce single stock futures into the mix of investment opportunities that an investment adviser may recommend to his or her clients or that an investment company manager may purchase for its affiliated investment company. It does so, however, without regulation by the SEC which would leave investors in funds consisting of single stock futures without the same protections that investors in mutual funds have enjoyed since 1940.
We would also point out that the bill fails to prevent disruption to existing securities markets. More specifically, language in the bill, such as the addition of definitions of ''option'' and ''nonexempt security'' to the CEA, makes it unclear whether CFTC exclusive jurisdiction over some products would be expanded, removing securities laws protections for those products that investors have come to expect. Moreover, the rule of construction in section 23 of the bill exacerbates this problem.
Other limitations on the SEC's authority are also problematic. For instance, the SEC no longer will be able to prevent use of broad-based securities indexes that lend themselves to manipulation of the securities markets. Current SEC authority leaves little cause for concern as we exercise our discretion carefully. We have worked closely with the CFTC for many years on nearly 70 stock index futures proposals.
Page 74 PREV PAGE TOP OF DOC Moreover, trading in single stock futures would commence without clear, explicit provisions for coordinated surveillance across markets. Detecting schemes, for instance, where a fraud is perpetrated in one market and profits taken in another ultimately goes to the integrity of existing capital markets. This threat to the well-being of the financial markets cannot be tolerated.
Once again, the Commission appreciates the efforts that the Subcommittee has made in bringing derivatives issues to the forefront. Starting a dialog is always an important first step. While we stand ready to review in more detail issues that the bill presents, we look forward to working with the Subcommittee to craft a modern legislative approach to these issues that fosters competition, bolsters market integrity, and ensures that no harm befalls America's capital markets. Only then can the promise of these products to American investors be fulfilled.
The Commission appreciates this Subcommittee's efforts with respect to derivatives issues. Just as derivatives products themselves can be complex, so to are the issues that surround these products. Having regulated derivative products for decades, the Commission welcomes the opportunity to actively participate in the dialog about derivative products that your bill will engender. We look forward to sharing our views with your Subcommittee, the Working Group, market participants, and other legislators as changes continue to be considered.
Statement of Lewis A. Sachs
Mr. Chairman, Ranking Member Condit, members of this subcommittee, I appreciate the opportunity to appear before you today to discuss H.R. 4541, the Commodity Futures Modernization Act of 2000. The introduction of this legislation is an important step in the modernization of the regulatory structure of the U.S. derivatives markets. I would like to commend you, Mr. Chairman, for the leadership and interest you have demonstrated in addressing these complex but very important issues. They are fundamental to the competitiveness and integrity of our markets.
Page 75 PREV PAGE TOP OF DOC After a brief discussion of the Over-the-Counter derivatives markets, I would like to focus my remarks on H.R. 4541 and its potential effect on the regulatory structure of the derivatives and other financial markets.
Background. In previous testimony before this subcommittee, I have highlighted the importance of the OTC derivatives markets to our economy.
By helping businesses and financial institutions to hedge their risks more efficiently, derivatives enable them to pass on the benefits of lower costs to American consumers and businesses.
By allowing for the transfer of unwanted risk, derivatives promote more efficient allocation of capital across the economy, increasing productivity.
By providing better pricing information, derivatives can help promote greater liquidity and efficiency in the underlying cash markets.
Finally, by enabling more sophisticated management of assets, including mortgages, consumer loans, and corporate debt, derivatives can help lower mortgage payments, insurance premiums, and other financing costs for American consumers and businesses.
To continue to reap such benefits, however, we must ensure that our regulatory and legal framework keeps pace with rapid progress in the marketplace. While the current framework here in the United States remains outdated, markets overseas are developing in a legal and regulatory environment that allows greater efficiency, transparency and liquidity. This is not simply the result of less regulation, but rather of more rational regulation and an environment of legal certainty.
Unless our laws and regulations relating to derivatives are modernized, we run the risk that innovation will be stifled by the absence of legal certainty, depriving the American economy of the benefits that the derivatives markets can provide, and hampering the efforts of our OTC and exchange-traded markets and businesses to compete globally.
Page 76 PREV PAGE TOP OF DOC While it is important to update these laws, it is important to do so with the recognition that the emergence of these markets has occurred during an era of unprecedented economic growth and prosperity. It is to be expected that in times of distress some participants in these markets, as in other financial markets, will be adversely affected. The recommendations we have made, and the provisions in this bill will not prevent these situations from occurring, nor are they intended to do so. What needs to be protected, however, is the financial system as a whole, and not individual institutions. We believe that our recommendations with respect to clearing and those designed to enhance transparency and legal certainty and to clarify the treatment of derivatives in the case of bankruptcy or insolvency can contribute to enhancing the stability of the system more broadly.
The challenge before this Subcommittee and the Congress is to establish a regulatory regime that will strike a balance between allowing the economy to realize more fully the benefits of derivatives and, at the same time, ensuring the integrity of the underlying markets, providing appropriate protection for retail customers, and where possible, taking steps to mitigate systemic risk.
When I last testified before this Subcommittee, I outlined the primary objectives of the Working Group with respect to legislation in this area. They are:
To reduce systemic risk in the OTC derivatives market by removing legal impediments to the development of clearing systems and ensuring that those systems are appropriately regulated.
To promote innovation in the OTC derivatives market by providing legal certainty for OTC derivatives and electronic trading systems. This would strengthen the overall legal framework governing the OTC derivatives market that, in turn, would stimulate even greater competition, transparency, liquidity, and efficiency and deliver stronger benefits to U.S. consumers and businesses.
Page 77 PREV PAGE TOP OF DOC To protect retail customers by ensuring that appropriate regulations are in place to deter unfair practices in all markets in which they participate and by closing existing legal loopholes that allow unregulated entities to pursue such unfair practices.
To maintain U.S. competitiveness by providing a modernized framework that will lead those engaged in the financial services industry to continue the operations of their businesses in the United States, and thereby assuring the continued leadership of our capital markets.
Given the scope of this billproviding legal certainty to OTC derivatives, reforming the Shad-Johnson Accord, and providing regulatory relief for futures exchangestoday I would add a fifth important objective:
To protect the integrity of the markets underlying the derivatives in questionin particular, the securities markets.
A balanced bill should meet these important objectives.
H.R. 4541: THE COMMODITY FUTURES MODERNIZATION ACT OF 2000
Let me now turn to H.R. 4541, the specific bill before this subcommittee. Mr. Chairman, while much of my testimony today will focus on specific concerns that we have with certain provisions of this bill, we are supportive of your efforts to ensure that these important issues are addressed in a timely manner. We are committed to working closely with you, your staff, and other members of Congress to facilitate the enactment of this important legislation. It is in this spirit of cooperation that the Treasury Department has identified a number of specific concerns in the three main components of this bill that we believe must be addressed in order to ensure that the final legislation maintains the integrity of our markets and satisfies the objectives set forth by the President's Working Group.
OTC Derivatives. Let me first address OTC derivatives. This bill largely incorporates the recommendations of the Working Group with respect to OTC derivatives which, if enacted, would create an environment of greater legal certainty for these instruments. We do, however, have two concerns in this area.
Page 78 PREV PAGE TOP OF DOC Clearinghouses: Our primary concern relates to the treatment of clearinghouses. The Working Group's report recommended that Congress enact legislation to provide a clear basis for the development of appropriately regulated clearing systems for OTC derivatives. Well-designed clearinghouses can help to reduce systemic risk: first, by diminishing the likelihood that the failure of a single market participant can have a disproportionate effect on the market as a whole; and second, by facilitating the offsetting and netting of contract obligations. In addition to these benefits, however, clearing tends to concentrate risks and certain responsibilities for risk management in a central counterparty or clearinghouse. Therefore, appropriate regulation of clearing systems is essential to ensure that they indeed serve to mitigate systemic risk.
Under the Working Group framework, regulatory oversight could be provided by the CFTC, SEC, a Federal banking regulator, or by a recognized foreign regulatory authority, depending on the structure of the clearinghouse and its activities. Legislative action could have the beneficial effects of reducing systemic risk by encouraging the development of such systems through the clarification of their legal status and by subjecting them to appropriate supervision. The bill, as currently drafted, permits the development of clearinghouses, but does not ensure that they will be appropriately regulated.
This bill allows but does not require entities that meet certain standards to register with the CFTC as Derivative Clearing Organizations (DCOs) and grants the CFTC exclusive jurisdiction with respect to such registered DCOs. We have two concerns with this approach: first, regulatory oversight is optional on the part of the clearinghouse; second, the exclusive jurisdiction of the CFTC may preclude securities regulators from maintaining oversight of organizations that clear securities-related transactions.
Consistent with the Working Group's report, we believe H.R. 4541 should be amended to make regulation of clearinghouses mandatory, and to permit the regulation to be carried out by the appropriate functional regulator. This recommendation is consistent with current practice, in which clearing systems for other markets operate under regulatory oversight.
Page 79 PREV PAGE TOP OF DOC Eligibility: Our second concern relates to part of the definition of eligible participant. The bill, as drafted, maintains a lower threshold for the definition of eligible participant than that recommended by the Working Group. We maintain that participation in this market should be limited to institutions, or individuals with substantial resources. The provision contained in the bill does not meet this standard. Therefore we recommend that the Subcommittee adopt the threshold contained in the Working Group's report.
The Shad-Johnson Accord. Let me now turn to the section of the bill addressing reform of the Shad-Johnson Accord. The members of the Working Group agreed that the current prohibition on single-stock futures could be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. Our view remains unchanged.
The provisions contained in this bill regarding futures on non-exempt securities are a good starting point, although a number of issues remain unresolved. The bill addresses some of the customer protection and enforcement concerns identified by the CFTC, the SEC, and others as necessary conditions for repealing the prohibition on single-stock futures. However, there are a number of concerns that the regulatory agencies consider important, but that have not been resolved in the legislation. We hope that the SEC and CFTC can provide specific comments on these issues in the near future so that they can be incorporated into this bill.
In addition, certain issues related to the harmonization of margin requirements will need to be clarified. While we do not see the need to establish margin requirements in statute, it will be important to establish margin levels that do not encourage regulatory arbitrage or lead to a substantial increase in leverage in our financial system.
While we have no objection to the introduction of single-stock futures, it is vitally important that the integrity of the underlying markets be preserved, and that these instruments not be used as a means to avoid the regulations of the cash markets. Therefore, we continue to be supportive of efforts by the SEC and CFTC to reach an agreement on a regulatory framework for these products that preserves the integrity of the underlying securities markets. In addition, we are supportive of actions taken by Congress to urge progress in these discussions. However, if these issues cannot be resolved on a timely basis, we believe that it is important to move forward with legislation designed to clarify the legal certainty for OTC derivatives.
Page 80 PREV PAGE TOP OF DOC Regulatory Relief. The third component of this bill addresses regulatory relief for the futures exchanges. The Treasury Department continues to support the view that it is appropriate to review, from time to time, existing regulatory structures to determine whether they continue to serve valid regulatory functions. Like the OTC markets, exchange trading of derivatives should not be subject to regulations that do not have a public policy justification. Broadly, we are supportive of the CFTC's efforts to provide appropriate regulatory relief to the futures exchanges, consistent with the public interest. To this end, the CFTC has recently released its regulatory relief proposal for public comment. We will be submitting a formal comment letter on this proposal in the near future.
There may, however, be unforeseen consequences to legislating such regulatory relief. Once such provisions are written into law, the regulators will have no ability to review and amend them should subsequent market developments warrant change or should other problems arise. Again, we are supportive of appropriate regulatory relief for futures exchanges, but suggest that certain aspects of that relief may be more appropriately provided through administrative action.
In particular, we are concerned with the provisions in H.R. 4541 regarding exempt boards of trade. To encourage innovation, the Working Group recommended an exclusion from the Commodity Exchange Act for electronic trading systems that satisfy certain criteria. Although the bill contains provisions to enact this exclusion, it also contains a statutory exemption for certain electronic and physical trading facilities. These ''exempt boards of trade'' would remain subject to the CEA's ''exclusive jurisdiction'' clause, thereby precluding regulatory oversight by other agencies.
The potential impact of this provision on the government securities market is of particular concern to the Treasury Department. In 1986, Congress passed the Government Securities Act to provide an appropriate regulatory framework for the government securities markets in direct response to a number of problems in the unregulated portion of this market. In 1993, in response to incidents of wrongdoing in Treasury auctions, Congress strengthened these laws to provide additional protection against market abuses.
Page 81 PREV PAGE TOP OF DOC Under some interpretations, H.R. 4541 could allow futures on government securities to escape most of the provisions of the CEA that currently apply to them, but would block regulation under the Government Securities Act. In addition, securities market participants that are currently regulated under the Government Securities Act could potentially restructure themselves as exempt boards of trade to evade regulation under both statutes. This has the potential to undermine the laws that Congress put in place in recent years that were designed to uphold and strengthen the integrity of the government securities market. Any reduced confidence in the integrity of the government securities market could lead to higher financing costs for the Treasury and thus an increased burden on American taxpayers. For these reasons, we strongly recommend that those provisions of the bill related to exempt boards of trade be removed, or amended to preclude the trading of securities-related products on those systems.
Again, we note that the CFTC's regulatory relief proposalthe basis for the regulatory relief sections of this billhas only recently been made available for public comment, and may be modified before implementation. We look forward to commenting on the proposal and working with the CFTC on these issues.
Bankruptcy. Mr. Chairman, although not part of this bill, I would like to take this opportunity to strongly urge Congress to adopt the President's Working Group recommendations regarding the treatment of these instruments and certain other financial contracts in cases of bankruptcy or insolvency. Rarely are there tangible steps the government can take that could have a meaningful impact on the mitigation of systemic risk. Enacting the recommendations of the Working Group designed to clarify the treatment of these instruments in bankruptcy is one of those steps. By establishing a framework through which creditors and counterparties can work out a swift resolution in cases of bankruptcy or insolvency, enactment of these recommendations can serve to reduce the impact of the failure of any one institution on the stability of the system more broadly.
Page 82 PREV PAGE TOP OF DOC Mr. Chairman, you have gone to great lengths to build consensus among the members of this committee, the Working Group and market participants on a difficult set of issues. We appreciate the leadership you have demonstrated and want to be constructive and helpful in moving forward a bill that we can support. It is in that spirit of cooperation that we have suggested a number of changes to your bill. We hope that as you finalize this bill, we can continue to work together to strike the appropriate balance to ensure that much-needed legislative changes are made that will promote innovation, protect retail customers, reduce systemic risk, maintain U.S. competitiveness, and ensure the integrity of our markets.
ANSWER TO SUBMITTED QUESTION FROM MR. STENHOLM
Question. We are witnessing many changes in the financial services industry that certainly have to be considered in any effort to modernize regulatory systems. Could you touch on the significance you see for regulation in rapid evolution of new communications technology, of global interactions, and of changes in the structure of financial services businesses and exchanges?
Answer. The recent pace of change in the financial markets has been dramatic: new technologies and improved communications have allowed investors to participate in global financial markets to an unprecedented degree. At the same time, the markets themselves have grown increasingly complex as financial professionals have developed the ability to price and trade risks in new and innovative ways.
The changes resulting from technology, globalization and financial innovation have made it increasingly important that our regulatory and legal framework keeps pace with rapid progress in the marketplace. This does not mean that our goal simply should be less regulation, but rather more rational regulation and an environment of legal certainty, which together will contribute to improved transparency, efficiency and innovation. Capital will tend to flow to the markets that offer the best combination of these elements.
Page 83 PREV PAGE TOP OF DOC One of the greatest challenges for policymakers in this environment will be to foster a legal and regulatory system that balances the need to preserve market integrity, protect retail customers and mitigate systemic risk with the goal of allowing the economy to realize fully the benefits of financial innovation.
The Working Group recommendations with respect to OTC derivatives were an attempt to strike that balance. In that regard, our primary objectives may be applicable more broadly. They are:
Reduce systemic risk;
Protect retail customers;
Maintain U.S. competitiveness;
and a fifth objective,
To protect the integrity of the underlying markets.
Statement of Patrick M. Parkinson
I am pleased to be here to present the Federal Reserve Board's views on legislation to modernize the Commodity Exchange Act (CEA). The Board continues to believe that such legislation is essential. To be sure, the Commodity Futures Trading Commission (CFTC) has recently proposed issuing regulatory exemptions that would reduce legal uncertainty about the enforceability of over-the-counter (OTC) derivatives transactions and would conform the regulation of futures exchanges to the realities of today's marketplace. These administrative actions by no means obviate the need for legislation, however. The greatest legal uncertainty affecting OTC derivatives is in the area of securities-based transactions, to which the CFTC's exemptive authority does not extend. Furthermore, as events during the past few years have clearly demonstrated, regulatory exemptions carry the risk of amendment by future commissions. If-our derivatives markets are to remain innovative and competitive internationally, they need the legal and regulatory certainty that only legislation can provide.
Page 84 PREV PAGE TOP OF DOC The Board commends this committee for introducing comprehensive legislation (H.R.-4541) that addresses these critical issues. In my remarks today I shall focus on the three principal areas that the legislation covers: (1) OTC derivatives; (2) regulatory relief for U.S. futures exchanges; and (3) repeal of the Shad-Johnson restrictions on the trading of single-stock futures.
In its November 1999 report, Over-the-Counter Derivatives and the Commodity Exchange Act, the President's Working Group on Financial Markets (PWG) concluded that OTC derivatives transactions should be subject to the CEA only if necessary to achieve the public policy objectives of the actdeterring market manipulation and protecting investors against fraud and other unfair practices. In the case of financial derivatives transactions involving professional counterparties, the PWG concluded that regulation was unnecessary for these purposes because financial derivatives generally are not readily susceptible to manipulation and because professional counterparties can protect themselves against fraud and unfair practices. Consequently, the PWG recommended that financial OTC derivatives transactions between professional counterparties be excluded from coverage of the CEA. Furthermore, it recommended that these transactions between professional counterparties be excluded even if they are executed through electronic trading systems. Finally, the PWG recommended that transactions that were otherwise excluded from the CEA should not fall within the ambit of the act simply because they are cleared. The PWG concluded that clearing should be subject to government oversight but that such oversight need not be provided by the CFTC. Instead, for many types of derivatives, oversight could be provided by the Securities and Exchange Commission (SEC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve, or a foreign financial regulator that the appropriate U.S. regulator determines to have satisfied its standards.
The provisions of H.R. 4541 that address OTC derivatives are generally consistent with the PWG's conclusions and recommendations. However, the Board is troubled by a provision that might leave uncertainty about whether some electronic trading systems for financial contracts between professional counterparties were subject to the CEA. Specifically, restricting exclusions for transactions conducted on electronic trading facilities to ''bona fide'' principal-to-principal transactions is unnecessary and undesirable. This restriction could be construed to preclude a counterparty from entering into ''back-to-back'' principal-to-principal transactions, that is, from using an excluded electronic trading system to hedge transactions executed outside the trading system. We can identify no public policy reason for precluding such back-to-back transactions. Doing so would discourage the use of electronic trading systems and thereby inhibit realization of the improvements in market efficiency and transparency that such systems promise to deliver.
Page 85 PREV PAGE TOP OF DOC In addition, H.R. 4541 does not require government oversight of clearing organizations for OTC derivatives, contrary to the recommendation of the PWG. The Board continues to believe that such oversight is appropriate and that alternatives to CFTC oversight should be provided. In-this regard, the Board recommends incorporating into legislation the provisions of H.R. 1161 (the bill that House Banking Committee Chairman James A. Leach introduced in April), which would enhance the Federal Reserve's authority to oversee clearing organizations that choose to be regulated as uninsured state member banks and would clarify the treatment of bank clearing organizations (including those overseen by the OCC) in bankruptcy.
REGULATORY RELIEF FOR U.S. FUTURES EXCHANGES
The PWG did not make specific recommendations about the regulation of traditional exchange-traded futures markets that use open outcry trading or that allow trading by retail investors. Nevertheless, it called for the CFTC to review the existing regulatory structures, particularly those applicable to financial futures, to ensure that they remain appropriate in light of the objectives of the CEA. In February, the CFTC published a report by a staff task force that provided a comprehensive review of its regulatory framework and proposed sweeping changes to the existing regulatory structure. We understand that the regulatory relief provisions of H.R.-4145 are intended to codify these proposals.
Using the same approach as the PWG, the CFTC has evaluated the regulation of futures exchanges in light of the public policy objectives of deterring market manipulation and protecting investors. When contracts are not readily susceptible to manipulation and access to the exchange is limited to sophisticated counterparties, the CFTC has proposed alternative regulatory structures that would eliminate unnecessary regulatory burden and allow domestic exchanges to compete more effectively with exchanges abroad and with the OTC markets. More generally, the CFTC proposes to transform itself from a frontline regulator, promulgating relatively rigid rules for exchanges, to an oversight agency, assessing exchanges' compliance with more flexible core principles of regulation.
Page 86 PREV PAGE TOP OF DOC The Board supports the general approach to regulation that was outlined in the CFTC's proposals. For some time the Board has been arguing that the regulatory framework for futures trading, which was designed for the trading of grain futures by the general public, is not appropriate for the trading of financial futures by large institutions. The CFTC's proposals recognize that the current ''one-size-fits-all'' approach to regulation of futures exchanges is inappropriate, and they generally incorporate sound judgments regarding the degree of regulation needed to achieve the CEA's purposes.
Furthermore, the Board generally supports codification of the CFTC's proposals so as to provide the exchanges with greater certainty regarding future regulation. However, the Treasury Department is concerned that the exempt board of trade provisions might have unintended consequences that could reduce the effectiveness of the existing regulatory framework for the trading of government securities. It may be prudent, therefore, to limit the codification of the exempt board of trade provisions, at least so that markets currently regulated under the Government Securities Act of 1986 are not affected. This would allow the CFTC to address any unintended consequences for the regulation of government securities by changing the terms of its exemptions.
The PWG concluded that the current prohibition on single-stock futures (part of the Shad-Johnson Accord) can be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. The Board believes that these issues can and should be resolved through negotiations between the CFTC and the SEC. The Congress should continue to urge the two agencies to settle their remaining differences so that investors have the opportunity to trade single-stock futures, both on futures exchanges and on securities exchanges.
If it would facilitate repeal of the prohibition, the Board is willing to accept regulatory authority over levels of margin on single-stock futures, as provided in H.R. 4541, so long as the Board can delegate that authority to the CFTC, the SEC, or an Intermarket Margin Board consisting of representatives of the three agencies. The Board understands that the purpose of such authority would be to preserve the financial integrity of the contract market and thereby prevent systemic risk and to ensure that levels of margins on single-stock futures and options are consistent. The Board would note that, for purposes of preserving financial integrity and preventing systemic risk, margin levels on futures and options should be considered consistent, even if they are not identical, if they provide similar levels of protection against defaults by counterparties, taking into account any differences in (1) the price volatility of the contracts, (2) the frequency with which margin calls are made, or (3) the period of time within which margin calls must be met.
Page 87 PREV PAGE TOP OF DOC In conclusion, the Board continues to believe that legislation modernizing the Commodity Exchange Act is essential. The Board appreciates this committee's efforts to foster the consensus necessary to enact legislation. Although some difficult issues remain unresolved, H.R. 4541 represents significant progress toward that goal.
ANSWERS TO SUBMITTED QUESTIONS FROM MR. STENHOLM
Question. We are witnessing many changes in the financial services industry that certainly have to be considered in any effort to modernize regulatory systems. Could each of you touch on the significance you see for regulation in rapid evolution of new communications technology, of global interactions, and of changes in the structure of financial services businesses and exchanges?
Answer. All of these factors are intensifying competition in the financial services industry, both domestically and internationally. The intensification of competition implies that when transactions or markets are burdened by legal uncertainty or unnecessary regulation, activity is much more likely to shift to jurisdictions that are free from such burdens. As a consequence, where our legal and regulatory structure for financial services is out of date, modernization is increasingly urgent.
Question. In its testimony, the SEC criticizes H.R. 4541 for failing to adequately harmonize securities and futures margin requirements. Could the SEC elaborate and the other two comment on these concerns?
Answer.Although the margin provisions of H.R. 4541 need clarification, with such clarification they can provide an adequate framework for ensuring harmonization. The bill grants authority over margin levels to the Federal Reserve Board. Although the Federal Reserve could delegate its authority to the CFTC or, with the concurrence of the CFTC and SEC, to an Intermarket Margin Board comprised of representatives of the three agencies, the Board would be responsible for ensuring that margin levels are harmonized.
Page 88 PREV PAGE TOP OF DOC It would be useful to clarify what it means for margins to be harmonized. The bill currently states that the level of margin on a futures contract shall be no less than the level of a margin on comparable options contracts listed on any national securities exchange. However, there is no single level of margin for options on a particular security. The basic structure of margin requirements for customers in the securities options markets is to require the seller (but not the buyer) to post margin equal to the current market value of the option plus some percentage of the underlying. For any particular security, multiple options are trading at any time, with the premium differing, depending, among other things, on the strike price and the expiration date. Thus, the implications of this requirement are not at all clear.
As stated in our testimony, a better approach would be to require the level of margin on a future to be consistent with the level of margin on the comparable option contracts listed on any national securities exchange. The legislation should further provide that in this context margin levels on futures and options should be considered consistent, even if they are not identical, if they provide similar levels of protection against defaults by counterparties, taking into account any differences in (1) the price volatility of the contracts, (2) the frequency with which margin calls are made, or (3) the period of time within which margin calls must be met.
Question. Do the regulators feel generally that current margin requirements give an edge to futures markets trading of futures on stock indexes and options on those futures over securities markets trading options on stock indexes? If so, why hasn't this advantage led to the failure in the marketplace of the securities exchange products?
Answer. We are aware of no evidence that margin requirements currently give futures markets an edge over options markets.
Question. You suggest in your testimony that a test of the consistency of margins should incorporate differences in volatility, frequency of margin calls, and the required periods for meeting margin calls.
Page 89 PREV PAGE TOP OF DOC Are the differences in trade settlement times between futures and securities markets also relevant to any determination of consistency? Can you provide the Subcommittee with any guidance as to how to treat this question?
Answer. As indicated in my answer to A.1., differences in the frequency with which margin calls are made or the period of time within which margin calls must be met are relevant factors in determining the consistency of margins. As suggested above, these should be specified as relevant factors in the legislation.
Question. In your testimony (page 23), you express concern that the bill's exclusion for contracts on electronic trading system is limited to ''bona fide'' principal-to-principal transactions?
Wasn't it the Working Group that suggested that transactions be limited on a principal-to-principal basis? If so, is your concern over the term ''bona fide''? Why would the term ''bona fide'' cause a concern unless you were looking for a loophole in the principal-to-principal restriction?
Answer. Yes, the Working Group recommended that excluded transactions be limited to principal-to-principal transactions. The Board's concern is with the term ''bona fide.'' Its use implies that there is some class of principal-to-principal transactions that are not excluded. The Working Group recommended that all principal-to-principal transactions be excluded. Insertion of the term ''bona fide'' is unnecessary and, given its vagueness, leaves market participants facing legal uncertainty as to whether their principal-to-principal transactions are, in fact, excluded from the CEA and its exchange trading requirement.
Statement of the Chicago Mercantile Exchange
Page 90 PREV PAGE TOP OF DOC The Chicago Mercantile Exchange welcomes the opportunity to supplement the record of the hearing conducted by the Subcommittee On Risk Management, Research, and Specialty Crops. On May 19, 1999, the Exchange appeared before that committee to offer its view of the reauthorization process and the important issues facing the industry and the Commission. Even at that early stage, the CME and the Chicago Board of Trade had taken the lead and proposed a legislative framework for rationalizing the regulation of derivatives markets.
The CME and CBOT were joined by the New York Mercantile Exchange in our effort to craft amendments to the Commodity Exchange Act to enhance competition and customer opportunity. We proposed five principles and a long list of detailed proposals. We proposed a means to rationalize the CEA and to restore internal consistency in concert with sound public policy. Within our framework, each segment of the industry, other than securities exchanges, which seek protection from legitimate competition, got exactly what it had been publicly seeking. Our proposal went farther than the OTC request for codification of the swaps exemption. We proposed that swaps could be cleared without losing their exemption. We were diligently following advice of congressional leaders that we needed to gain sufficient support from the derivatives industry to ensure passage of much needed reform legislation. We proposed a five-part plan:
Convert the CFTC to an oversight agency;
Reform the artificial competitive constraints imposed by the Shad/Johnson Accord;
Expand access to futures markets;
Provide legal certainty to OTC markets; and
Level the regulatory playing field.
Since that testimony, most of the participants and regulators in the financial services industry appeared to be working to find a compromise proposal. The President's Working Group on Financial Markets issued an extensive report. On February 28, 2000, the Department of the Treasury submitted a draft amendment to the Commodity Exchange Act based on its view of the recommendations of the PWG.
Page 91 PREV PAGE TOP OF DOC On February 22, 2000, CFTC Chairman Rainer sent the report of the CFTC Staff Task Force, titled ''A New Regulatory Framework'' to Senator Richard G. Lugar, Chairman of the Senate Committee on Agriculture, Nutrition, and Forestry, and Representative Larry Combest, Chairman of the House Committee on Agriculture. The CFTC's report suggests use of the Commission's exemptive power to create a regulatory environment that will permit the futures industry to accommodate itself to real world conditions. The goal was to move the agency toward an oversight standard and to limit regulation to the extent necessary to accomplish legitimate regulatory goals.
Chairman James A. Leach, House Banking and Financial Services Committee, floated a ''Discussion Draft'' bill dated March 14, 2000, and conducted hearings on April 11, 2000. His bill's purpose is: ''To establish a comprehensive regulatory framework over the clearing of over-the-counter derivative instruments that will operate under the supervision of the Federal banking agencies . . . .''
The Leach draft operates by amending the Federal Deposit Insurance Corporation Act of 1991 and including provisions on ''Legal Certainty'' (section 4) and ''Electronic Trading (section 5). Both sections 4 and 5 create rules of construction intended to exclude trading in futures contracts from the Commodity Exchange Act without amending that act. The draft also creates a regulatory program for clearing of over-the-counter derivatives under the aegis of Federal banking authorities. We agreed with several of Chairman Leach's concepts but urged that all necessary amendments to the CEA be captured in a single bill. We testified that we intended to focus on the bills that would be considered by the agricultural committees.
Chairman Ewing held extensive hearings, listened to all views and concluded that the time is ripe to alleviate the excessive regulatory burdens that have greatly disadvantaged U.S. futures exchanges in comparison to their global competition. Chairman Ewing sought a consensus-driven solution that balanced the interests of all participants in the financial services industry.
Page 92 PREV PAGE TOP OF DOC This intensive effort by Chairman Ewing and the staff of this committee produced H.R. 4541, which was the subject of the June 14, 2000, hearing. We are on record praising H.R.4541 as providing a significant reform of financial services regulation and creating a more equitable regulatory environment for futures exchanges. By providing a comprehensive approach to the inter-related goals of modernizing exchange regulation, reforming Shad-Johnson and establishing legal certainty for the OTC market, this bill appropriately balances the interests of all participants in the financial services industry.
The hearing was particularly useful in forcing the Department of the Treasury and the Securities and Exchange Commission to clarify their interpretation of the goals of the PWG Report. Contrary to common understanding, it is now clear that neither Treasury nor the SEC intended to support broad deregulation of futures exchanges or the OTC market. Instead, as each agency testified, it was their intent to eliminate or constrain the CFTC's jurisdiction in order to permit the SEC to become the dominant regulator of derivatives that have some securities flavor.
The SEC testified that its cure for legal uncertainty issues was application of securities laws rather than commodity laws. The SEC incorrectly asserted that legal certainty was improved under their regime because rescission was not available as a remedy under the securities laws. If in fact, the goal of the PWG had been to eliminate the potential for avoidance of OTC swap contracts, a simple amendment to the CEA would have been sufficient. It would not have been necessary to revamp CFTC jurisdiction to cure that problem.
During its testimony, the SEC refused to support legal certainty through deregulation in respect of any product over which it might claim jurisdiction. Treasury took an identical position. Treasury testified that it could not tolerate the purchase and sale of derivatives related to government securities in an unregulated, or reduced regulatory, environment. Both Treasury and the SEC seem to oppose the H.R. 4541 to the extent that it seeks deregulation in their backyards. This is certainly contrary to what most observers thought had been proposed by the PWG report
Page 93 PREV PAGE TOP OF DOC We strongly support Chairman Ewing's proposal to reform the Shad/Johnson Accord. Eighteen years ago, the Shad-Johnson Accord resolved a jurisdictional conflict between the SEC and the CFTC. It included a temporary ban on most equity futures contracts. It was not intended as a permanent barrier to innovation and growth. Futures exchanges were able to develop broad based stock index futures under Shad/Johnson. Those products have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements.
The CME's long standing goal is freedom to list and trade futures contracts now forbidden by the Shad/Johnson Accord without being subjected to multiple regulators and without changing the principles upon which futures trading has been conducted for more than 100 years. Remember, we created a tremendously useful product, equity indexes, in the face of overwhelming opposition. The SEC and its exchanges opposed futures on indexes with all of the same arguments that they now raise against futures on individual securities. Nonetheless, equity indexes are among the most popular contracts on securities exchanges as well as futures exchanges. Futures trading of equity indexes has enhanced customer opportunity with none of the ill consequences predicted by the SEC or securities exchanges. In fact, their business has directly benefited.
The options markets and swaps dealers offer customers risk management tools and investment alternatives involving both sector indexes and single stock derivatives. Futures exchanges have been frozen out. Shad/Johnson's ''temporary'' ban lasted 18 years during which time single stock futures have thrived in the OTC market in the form of equity swaps and on option exchanges in the form of synthetic futures. Recently the President's Working Group, the General Accounting Office and congressional leaders have all called for an end to the ban.
On December 17, 1999, Chairman Lugar and Chairman Gramm (Senate Banking Committee) asked CFTC Chairmen Rainer and SEC Chairman Levitt for a ''detailed report addressing the desirability of lifting the current prohibition on single stock futures together with any legislative proposals . . . no later than February 21, 2000.'' On January 20, 2000, Chairmen Combest, Ewing, and [House Committee on Commerce Chairman] Bliley asked the SEC and CFTC to create a ''joint legislative plan for repealing the current prohibition on single stock futures . . . no later than February 21, 2000.'' On March 2, Chairmen Levitt and Rainer responded by presenting ''the current views'' of the agencies, but failed to offer a specific legislative plan.
Page 94 PREV PAGE TOP OF DOC Of course, we are pleased that the CFTC and SEC have agreed that it is appropriate that U.S. exchanges be permitted to compete in world markets and offer U.S. customers the opportunity to manage risks by means of equity futures contracts. We are also pleased that they have found a way to accommodate their jurisdictional and regulatory concerns on several important issues. But it is far too late in the game to be satisfied with signs of progress. We share Senator Lugar's ''disappointment'' that the agencies were unable to resolve all of their jurisdictional concerns within the period requested.
Today, Shad-Johnson is a bar to useful competition. The SEC invoked Shad-Johnson to bar futures on the Dow Jones Utilities and Transportation Averagesbecause that index did not ''reflect'' the utilities and transportation sectors. The United States Court of Appeals overturned and vacated that SEC decision, Board of Trade v. Securities and Exchange Commission, No. 982923 (7th Cir., August 10, 1999). The court of appeals found: ''The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves . . . . The Securities and Exchange Commission, which regulates stock markets, has sided with its clients.'' Slip Op. at 4.
Congress intended the Shad-Johnson ban on single stock futures to be temporary. The court of appeals found that the ban ''was a political compromise; no one has suggested an economic rationale for the distinction.'' Slip Op. at 4. In the absence of such a rationale, Congress should lift the single stock futures ban and allow the marketplace to decide whether these instruments would be useful new risk management tools. Many exchanges around the world trade single stock futures; no reason exists to deny U.S. customers and markets the same opportunity.
H.R. 4541 will enact an appropriate division of responsibility between the SEC and CFTC for futures trading of contracts currently prohibited by the Shad/Johnson Accord. It protects the SEC's enforcement authority and forecloses avoidance of securities act proscriptions by means of futures contracts. It protects options exchanges from regulatory arbitrage arising out of disparate margin treatment. It serves the public interest in fair competition and access to new products. It imposes more restrictions on futures exchanges than we had hoped for but not so many that we will be unable fairly to test the markets appetite for new products.
Page 95 PREV PAGE TOP OF DOC The Board of Governors of the Federal Reserve System offered an excellent suggestion, which we embrace, to improve the language in H.R. 4541 respecting equivalence of margin between stock options and stock futures. The Board stated:
Margin levels on futures and options should be considered consistent, even if they are not identical, if they provide similar levels of protections against defaults by counterparties, taking into account any differences in (1) the price volatility of the contracts, (2) the frequency with which margin calls are made, or (3) the period of time within which margin calls must be met.
Last year, the 106th Congress took dramatic action and modernized regulation of most financial services firms by adopting the Gramm-Leach-Bliley Act. The consequences of excluding the derivatives industry from this progressive groundswell would be disastrous. We hope that Congress will act expeditiously on H.R. 4541 to ensure that complete financial regulatory reform becomes part of the legacy of this Congressional Session. We pledge to work diligently with Chairman Ewing and other members of the House to ensure that the all of the fundamental principles of this bill are enacted into law this year.
We appreciate this opportunity to supplement the record of this hearing.
Statement of the Bond Market Association
The Bond Market Association is pleased to comment on H.R. 4541, the Commodity Futures Modernization Act of 2000. H.R. 4541 represents an important step in the regulatory reform of the markets for derivative financial products. The bill includes a number of proposals designed to streamline the regulatory environment for derivatives, and clarify several important areas of legal uncertainty which result in undue systemic risk. For these reasons, we commend Chairman Ewing for his introduction of H.R. 4541 and we support these aspects of the bill.
Page 96 PREV PAGE TOP OF DOC Reauthorization of the Commodity Exchange Act presents an opportunity to clarify the regulation of certain financial products and to eliminate any misconception regarding the scope of authority provided under the CEA. We concur with the widely held belief that swaps are inappropriately regulated as futures, and we believe that the CEA should codify the principle that swaps should not be regulated as futures by the Commodity Futures Trading Commission. Such clarification would mitigate legal risk for market participants and would help maintain over-the-counter markets as viable alternatives to traditional, organized exchanges. It would also help avoid duplicative and unnecessary regulation. Congress has the opportunity through the CEA reauthorization to help assure that the capital markets can continue to operate as efficiently as possible.
The Bond Market Association represents securities firms and banks that underwrite, trade and sell fixed-income securities in the U.S. and international markets. Our interests in H.R. 4541 relate to how the bill would affect the efficient operation and regulation of the markets for bonds and other fixed-income securities and related instruments, and our comments will focus on just those aspects of the bill.
THE FINANCIAL MARKETS AND THE CEA
As the subcommittee is aware, the financial markets have grown increasingly complex in recent years. 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 contractseven 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.
Page 97 PREV PAGE TOP OF DOC 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 or unnecessary government regulation in the trading and clearance of debt instruments.
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 provisions of the bill which would reaffirm and clarify the Treasury Amendment and recommends additional changes;
supports the goals other provisions of H.R. 4541 designed to provide legal certainty for over-the-counter derivatives;
continues to analyze the effects of the bill's treatment of clearing organizations and the repeal of the Shad-Johnson accord on the bond markets; and
urges the adoption of separate legislation to reduce systemic risk in the financial markets by reforming bankruptcy and insolvency law.
The market for government securities is well regulated under a structure tailored to the unique qualities of the market. Under authority provided by the Government Securities Act of 1986 and subsequent 1993 amendments, the Treasury Department is a principal rulemaker for the government securities market. The Treasury Department, in consultation with other regulators, has published detailed rules regarding large position reporting and record-keeping. The National Association of Securities Dealers and bank regulators have published rules regarding sales practices. The SEC has broad authority to enforce antifraud statutes on government securities market participants. The CFTC and the organized exchanges, of course, regulate activity related to transactions in listed futures contracts on government securities. This balanced arrangement ensures that the government securities market remains safe and well-regulated in addition to serving as a model of market efficiency.
Page 98 PREV PAGE TOP OF DOC Efficient and sound regulation of the government securities market is important because it helps ensure that taxpayers pay the lowest possible interest cost on the government's borrowing and that other U.S. borrowers whose debt is priced relative to Treasury securitiescorporations, financial institutions, homebuyers, consumers and othersalso enjoy reasonable borrowing costs. There are approximately $3.1 trillion of marketable Treasury securities outstanding, and over $200 billion of Treasury securities change hands every day. Any undue risk or uncertainty regarding the market's regulatory structure can have significant effects on the government's interest cost and the interest rates faced by other borrowers.
When the CEA was first enacted in 1974, Congress included a provision precluding the CFTC from regulating ''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.'' This provision has become known as ''the Treasury amendment.'' The Treasury amendment is important because it helps prevent duplicative or conflicting regulation.
The Treasury amendment does not explicitly address questions regarding the regulation of financial products which involve government securities. These include, for example, instruments such as repurchase agreements, swap contracts and forward delivery contracts. This issue was addressed indirectly by the U.S. Supreme Court in its 1997 decision in Dunn v. CFTC, where the Court generally held that ''transactions in'' foreign currency encompass all transactions relating to foreign currency. Market participants widely believe that the same standard applies to other financial products covered under the Treasury amendment, including government securities.
H.R. 4541 would generally maintain the current structure of the Treasury amendment. The bill would specify that the CEA does not apply to transactions in government securities, foreign currency, security warrants, security rights, resales of installment loan contracts, repurchase transactions in a financial commoditya particularly important and welcome clarificationor mortgages or mortgage purchase commitments. Futures contracts related to these products traded on an ''organized exchange'' would still be subject to CFTC regulation under the bill. The bill retains existing statutory language, implying Congress' intent to embrace the Supreme Court's interpretation of such language. However, H.R. 4541 would not expressly codify the Supreme Court's interpretation of existing law regarding financial products involving the enumerated instruments. We therefore suggest amending H.R. 4541 to fully clarify the scope of the Treasury amendment provisions and address any remaining legal uncertainty regarding the scope of the Treasury amendment's applicability. In particular, we suggest adding language to Section 4 of the bill specifying that the Treasury amendment exclusions apply to transactions ''in or in any way involving'' the specified instruments.
Page 99 PREV PAGE TOP OF DOCORGANIZED EXCHANGES
H.R. 4541 would also clarify the applicability of the Treasury amendment by specifying an exception to the general exclusion for contracts traded on an ''organized exchange.'' Current law provides an exception to the Treasury amendment for contracts traded on a ''board of trade.'' The definition of ''board of trade'' is somewhat vague with respect to both evolving electronic trading systems and the roles of certain traditional market participants such as inter-dealer brokers. If ''board of trade'' was defined under current law to include electronic trading facilities or situations where market participants conduct transactions in a screen-based format and settle them through an independent clearing mechanism, significant market disruption would result. In particular, such a definition would subject already regulated markets to a duplicative layer of government regulation.
Although we support the basic outlines of the new statutorily defined term, the definition in the bill of ''organized exchange,'' with its use of the term ''bona fide,'' is vague with respect to certain trades which are conducted on a principal basis. In the fixed-income markets, it is not uncommon for a dealer to buy or sell securities in a ''back-to-back'' transaction with an investorwho may or may not be an ''eligible contract participant''on one side and another dealer or investor on the other. Clarification of this issue is extremely important to the bond markets because it goes to the heart of achieving legal certainty. We feel strongly that Congress should clarify, consistent with the bill's intent, that whenever an intermediary retains credit or execution risk in connection with a back-to-back transaction, it is acting as principal and not on behalf of any third party. This is true even if the credit or execution risk is mutualized through the auspices of a regulated clearing organization.
LEGAL CERTAINTY FOR OTC DERIVATIVES
Under current law, the CEA 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 futures contract. Under the CEA, over-the-counter 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 rescission. This harsh consequence of voiding a contract is particularly troublesome in light of the difficult 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 ability to abandon contract obligations when the CEA status of a financial transaction is challenged. H.R. 4541 includes two key provisions designed to address this problem.
Page 100 PREV PAGE TOP OF DOC First, the bill would specify that the CEA does not apply to over-the-counter derivative contracts entered into between ''eligible contract participants'' which are not conducted on a ''trading facility'' other than an ''electronic trading facility.'' Second, the bill would specify that financial contracts may not be rescinded ''solely on the failure of the agreement, contract, or transaction to comply with the terms or conditions of an exemption or exclusion from any provision of this Act or regulations of the Commission.'' Together, these two provisions represent a major step towards addressing the question of the ''legal certainty'' of over-the-counter derivative contracts, a goal which we fully support.
OTHER PROVISIONS OF H.R. 4541
In addition to the provisions cited above, The Bond Market Association offers these comments on other provisions of H.R. 4541:
Shad-Johnson accordAlthough presumably intended to permit single-stock futures, the bill expressly would allow futures on ''non-exempt securities,'' thereby permitting futures on single debt instruments. This would raise novel questions which until now have not been thoroughly analyzed. We are currently exploring these issues, and look forward to providing additional detail. If the intention of the subcommittee is to permit only single-stock futures, we suggest amending the bill's language to make that explicit.
Clearing organizationsWe are analyzing the potential effects of the bill on clearing organizations, and we look forward to providing additional input.
BankruptcyAlthough not part of H.R. 4541 and not within the jurisdiction of this subcommittee, the report of the President's Working Group on the Financial Markets on financial derivatives recommended the adoption of changes to the Bankruptcy Code and banking law designed to reduce systemic risk. The Working Group's recommendations would streamline the process by which financial contracts can be netted and resolved in cases of bankruptcy or insolvency. Legislation is pending in both the House and Senate to adopt these recommendations, and we are very supportive of these efforts.
Page 101 PREV PAGE TOP OF DOCSUMMARY
In recent years, we have seen a rapid acceleration in the development of new and sophisticated financial products designed to mitigate risk, reduce costs and enhance efficiency. Unfortunately, the evolution of our regulatory structure for financial derivatives has lagged behind the evolution of the markets themselves. It is appropriate, therefore, for Congress to address the uncertainty and risk which has arisen as a result of a system of regulation which never anticipated the market we have today.
The Bond Market Association supports provisions in H.R. 4541 designed to enhance and clarify the Treasury amendment. We also recommend additional changes to the Treasury amendment to clarify the treatment of products involving exempt instruments and to clarify the application of the ''organized exchange'' provision. We also support the goal of key provisions of the bill to provide legal certainty with respect to the regulation of over-the-counter derivatives. We are continuing to examine the implications of the Shad-Johnson repeal and the bill's treatment of clearing organizations on the bond markets, and we look forward to providing additional analysis and input. Finally, we urge the adoption of bankruptcy and insolvency legislation designed to reduce systemic risk in the financial markets.
We appreciate the opportunity to present our views on H.R. 4541. We commend Chairman Ewing and other members of the subcommittee for their quick action on these important issues, and we look forward to working with subcommittee members and staff as the legislative process moves forward.