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REAUTHORIZATION OF THE COMMODITY FUTURES TRADING COMMISSION
TUESDAY, JUNE 8, 1999
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to call, at 1:05 p.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Everett, Thune, Jenkins, Gutknecht, Riley, Walden, Hayes, Condit, Dooley, Pomeroy, Bishop, Goode, McIntyre, Stabenow, Etheridge, Boswell, Lucas of Kentucky.
Staff present: Dave Ebersole, senior professional staff; Stacy Carey, subcommittee staff director; Ryan Weston, Hunter Moorhead, 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 meeting of the Subcommittee on Risk Management, Research, and Specialty Crops will come to order.
I do want to indicate my appreciation for all of you on this panel for coming today. The Commodity Futures Trading Commission reauthorization is a very important and a very complicated issue. This is the final hearing in the series of hearings that have previously been scheduled. We have had very productive sessions, and today's witnesses will no doubt greatly add to our continued discussion of that reauthorization.
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The members of this subcommittee have spent a great deal of time listening to testimony and trying to bring themselves up to speed on the very complex issues that we must address as we address the deregulation or changes in regulatory structure, the Treasury amendment, the Shad-Johnson Accord, electronic trading, systems and legal certainty for over-the-counter instruments. So it is a very broad, very complex area that we address here.
CFTC's reauthorization affects everyone from the largest domestic and foreign bank down to the smallest farmer who tries to hedge his or her risk on the market. In the end, it will be up to this subcommittee to take from those hearings that we have had and those that we may have yet in the future information that we have gathered, continue to work that information, hopefully into a legislative form that can gain approval of the full committee, the House of Representatives and the U.S. Senate and something that we can send to the President for his consideration and hopefully for his signature that will take the CFTC and the industries that are regulated by it well into the next century with a system that is flexible, that is modern, that meets the needs of protecting customers, as well as the needs of the industry for a competitive system of regulation.
So with that, I want to express that the ranking member, Mr. Condit, was here and he has a security briefing and hopefully he will be back during this session of our hearing.
I am pleased that all of the witnesses are in their places, and I would say to you that we would be very appreciative if you would summarize your testimony. We will be using the 5-minute rule, and that will allow more time for questions.
Members of the panel are Dr. Charles D. Lambert, chief economist, National Cattleman's Beef Association, representing the Agriculture Producer Coalition; Dr. Daniel P. Dye, chairman, National Grain Trade Council; Mr. Kendell Keith, president, National Grain and Feed Association; Mr. Daniel J. Roth, vice-president and general counsel, National Futures Association; Mr. John G. Gaine, president, Managed Funds Association; and Mr. William P. Miller, chairman, End-Users of Derivatives Council of the Treasury Management Association.
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All of you are welcome, and we are going to start with Mr. Lambert.
STATEMENT OF CHUCK LAMBERT, CHIEF ECONOMIST, NATIONAL CATTLEMAN'S BEEF ASSOCIATION, REPRESENTING THE AGRICULTURE PRODUCER COALITION
Mr. LAMBERT. Thank you, Mr. Chairman. NCBA commends your continued efforts to improve risk management alternatives during the time of volatile prices for most agricultural products. I am Chuck Lambert, chief economist for the National Cattleman's Beef Association.
I should state at the outset that NCBA is part of a broader agricultural coalition that is working on a wide range of futures-related issues, including off-exchange agricultural trade options. A letter cosigned by coalition members, including NCBA, will also be submitted for the record and so my comments today will be specific to the beef industry.
Beef producers will require more alternatives to protect themselves from increased global price volatility. The rapid development of computer software and the growing importance of the Internet are revolutionizing the way that many stocks and bonds are traded. Futures markets will be impacted by these rapidly emerging technologies.
It is absolutely imperative that all markets operate free of legal and illegal market abuse. To achieve this result, NCBA strongly supports the following regulatory and educational activities: protect the integrity of agricultural futures markets and the cattlemen who choose to use these markets by enforcing existing laws and regulations. Maintain the CFTC as the independent and autonomous regulatory agency of the commodity futures and options trading industry and maintain agency reauthorization.
Although we support exclusivity, many in U.S. agriculture are concerned about recent CFTC initiatives to expand regulatory authority. These initiatives have detracted from regulatory efficiencies and CFTC is urged to focus future regulatory efforts within current authorization limitations.
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Maintain authority of commodity exchanges for setting margin requirements for futures and options contracts with CFTC oversight; require CFTC and CME to provide more detailed breakdown of long and short large-trader positions by contract held by producers, packers, and commodity funds in addition to the traditional breakdowns of commercial and noncommercial positions.
NCBA urges that no cross hedge exemptions be granted in excess of speculative limits for the purpose of hedging feeder cattle in the CME live cattle spot month contract. NCBA will oppose any legislation that does not allow an opportunity for input from the cattle industry on futures contract changes.
Initiate and expand educational programs for beef producers, not only in the mechanics of futures and options markets, but also on the application of these risk management tools.
Increase resources for basic commodity market research.
Encourage the development of live cattle futures contracts, wholesale boxed beef futures and options contracts and retail price futures and options contracts.
The selection of risk management tools in the form of futures and options contracts available within most agricultural commodities is limited in most cases to one contract per commodity. For example, in the case of fed cattle, the CME live cattle futures and options contracts are the only risk management tools available.
In the absence of competitive pressures and market alternatives, commodity groups have been forced to rely on negotiation with commodity exchanges and regulation and contract specifications to improve risk management tools for their members. These often have fallen on deaf ears.
Interest of the legitimate producers of the physical commodity are often ignored in favor of the floor traders who serve on the contract committees of the exchanges and more often than not have a vested interest in the status quo.
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Frustration and distrust among many major cattle feeders regarding the incestuous nature of exchange politics has hastened the move to contractual integration in the cash market as a risk management alternative to the use of futures and options markets.
FutureCom applied to the CFTC to become an Internet-based futures exchange as an alternative to current futures markets. If approved, FutureCom participants could trade contracts electronically directly on the Internet, rather than through an intermediary. Notice of FutureCom's application was initially published under delegated authority for public comment nearly 2 1/2 years ago on January 31, 1997.
Even with the complexities of breaking new ground, it would seem that the 2 1/2 years taken to date for CFTC to grant approval of this innovative concept is excessive, and I would note that it is not yet approved.
Based on the FutureCom experience, increased regulatory flexibility is crucial for the survival of creative and visionary entrepreneurs within the industry. It is critical that the CFTC be authorized to be innovative and flexible from a regulatory standpoint.
Congress is encouraged to work with industry and the CFTC in determining how much flexibility the commission needs to address the changing technological environment. The intense interest in electronic trading is fueled by at least two issues, rapidly increasing globalization of the futures and options markets, and tremendous advances in electronic trading technologies.
The lower transaction costs and the inherent benefits regarding oversight of electronic trading systems make them an attractive alternative to traditional trading methods. It obviously was not possible to contemplate the incredible advances in the markets today when the current laws and regulations were adopted.
Given increased regulatory agility, the CFTC can encourage and not impede those who think outside the box. Congress is encouraged to take a comprehensive look at the act with an eye towards making amendments to accommodate changes related to electronic trading. Provisions to designation of a completely electronic exchange should be reviewed.
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Also electronic trading systems may affect the design of exchange governance systems, and the current law pertains primarily to traditional membership exchanges as opposed to proprietary exchanges. NCBA looks forward to providing additional input as other marketing issues are addressed, including price reporting, labeling, and a whole host of trade issues.
Thank you for the opportunity to present this information.
Mr. EWING. Thank you, Mr. Lambert.
[The prepared statement of Mr. Lambert appears at the conclusion of the hearing.]
Mr. EWING. Mr. Dye.
STATEMENT OF DANIEL P. DYE, CHAIRMAN, NATIONAL GRAIN TRADE COUNCIL
Mr. DYE. Mr. Chairman and members of the subcommittee, good afternoon. My name is Dan Dye, and I am vice-president of Cargill North American Grain. I serve as the chairman of the National Grain Trade Council on whose behalf I appear before you this afternoon.
The council supports reauthorization of the Commodities Futures Trading Commission, although in our testimony we recommend changes to the Commodity Exchange Act which will affect the role of the CFTC.
The council believes reform of the CEA is overdue. The CEA has spawned a regulatory structure that today is stifling innovation in a rapidly changing world. We believe a successful effort to reform the CEA should focus on how to rationalize regulation.
Rationalizing regulation should include at least three elements: first, Federal oversight. The role of the CFTC should be one of Federal oversight. As a starting point, this framework would limit the role of the CFTC in areas like registration, reparations, and arbitration. As the role between the CFTC and the exchanges shifts, exchanges will need to be ever more attuned to the needs of market users and be accountable to those reliant on their products.
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Second, minimizing duplication of effort. The council believes that it is time to change the regulatory structure so it does not foster and encourage duplication of effort between the private and public regulators. We would like to see more clarity between the responsibilities of the CFTC, National Futures Association, and the exchanges.
The current system tends to promote duplication of effort in certain areas such as investigation and audits and contract design. Ideally, the front line of audit investigation authority should lie with the self-regulatory organizations, again with accountability to the users; and the CFTC would have strong authorities overseeing exchange enforcement performance.
For self-regulation to work, there must be confidence in each element of the system that would require a careful examination of the authorities and responsibilities of each of the regulatory entities, including the exchanges.
Third, efficient but meaningful regulation. The council believes some steps can be taken to streamline the regulatory structure and yield efficient but meaningful regulation. Rationalizing regulatory efforts and making them more efficient should not lower customer safeguards.
Exchanges should be allowed to list new contracts and implement new rules or rule changes without first seeking CFTC approval. The CEA should specify the guidelines for obtaining and maintaining contract market designation. The Federal regulatory agency in turn should be given adequate disciplinary tools to give contract markets an incentive to maintain strict compliance with the charter for contract market designation.
With those authorities in place, certain functions could be left to the self-regulatory organizations or the NFA. More clarity in the agency's role would help achieve this goal.
Achieving these three goals to rationalizing regulation will not be easy. We have studied with interest the concept proposal put forward by the Chicago Board of Trade and the Chicago Mercantile Exchange. Our initial reaction is favorable, and we see it as a positive step forward in a debate. We compliment the exchanges for some fresh thinking that is evident in their proposal. There are, however, many questions yet to be answered regarding the details of this proposal, and we look forward to be being part of that process.
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In discussing reforms to the CEA, another key element to rationalizing regulation is gaining similar regulatory treatment for comparable instruments. We are intrigued with the proposal from the Chicago exchanges which suggest that publicly traded derivatives would be traded on exchanges and privately negotiated derivatives would be traded in an unregulated over-the-counter market. Further work needs to be done on specific definitions, and clear language will be a necessity as this process continues.
There is an agricultural issue affected by this OTC debate and that is what is an appropriate regulatory structure for agricultural trade options. We believe the regulatory structure approved by the commission in 1998 for the ATO pilot program should be streamlined.
We believe the following changes should be made to that program: the exercise of the agricultural trade options should not require delivery. We would like to see the registration process for agricultural trade options merchants simplified. Producers should be allowed to write a covered call option.
We believe that once a trade option contract is purchased or sold, that the rules should allow the position to be offset prior to expiration and the requirements that agricultural trade option merchants must file quarterly reports on trade option transactions should be dropped.
The principal issue surrounding OTC derivatives is regulatory fairness. The Government should not create regulatory disparities to give one group a competitive advantage over another. We are concerned as we watch the Crop Insurance Program administered by the Federal Government evolve, and here are ideas to expand that program further.
We are not at all opposed to Government support for traditional multiple peril crop insurance, but we would caution expansion into revenue insurance products. We believe providing income support to producers should be separated from crop revenue insurance, and we believe that assistance should be provided in a manner that is simple, direct, nonmarket distorting and fair.
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The council strongly supports aggressive efforts to provide farmers and risk management education, and in particular with access to knowledge that will help them make informed marketing decisions. The Federal Government can play a constructive role in helping farmers become informed decision makers when managing their price risk.
Returning to recommendations for reforming the CEA, the council supports including a provision to provide a more modern definition of a hedge in the CEA. The current definition focuses on price risk reduction, and we would suggest the focus be more on risk management.
If a farmer or grain company would wish to seek to hedge their business risks through an area yield contract, for example, that should be considered a hedge even though it does not seek to reduce price risk. Also in the nature of modernizing the CEA is a request from the Kansas City Board of Trade to eliminate section 5a(a)7 in order to clarify this warehouse delivery provision of the CEA.
In conclusion, Mr. Chairman, we compliment you and Mr. Condit for your efforts to modernize the CEA to meet current and future demands of the U.S. and global markets and to see what CFTC's role should be in that.
We believe such a step is long overdue. We look forward to working with you on a solution that results in more rational regulation for exchanges, the OTC community, and market users. Thank you.
Mr. EWING. Thank you, Mr. Dye.
[The prepared statement of Mr. Dye appears at the conclusion of the hearing.]
Mr. EWING. Mr. Keith.
STATEMENT OF KENDELL KEITH, PRESIDENT, NATIONAL GRAIN AND FEED ASSOCIATION
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Mr. KEITH. Mr. Chairman and members of the subcommittee, our association appreciates the opportunity to participate in these hearings. We recognize this is a CFTC reauthorization hearing, but we would urge this committee to take a broad perspective on rethinking and reshaping Government's role in facilitating and regulating risk management activities.
There is a wide range of factors that are affecting both exchange and off-exchange activities necessitating, in our view, a more thorough consideration of how policies and regulators can interact to influence market outcomes.
We submit that Government must offer strong protection against market manipulation and fraud, that policies should encourage both liquidity and transparency of regulated exchanges; and we would urge less reliance on direct Government oversight in favor of more reliance on competitive market forces.
We do support reauthorization of CFTC. We believe futures markets still benefit from an independent regulator that is expert in the unique features of such markets, but we think that CFTC legal authorities should be more clearly defined and made more narrow.
Historically the CFTC has made wise judgments in administering a broadly written law, although more recently the agency seems to have struggled in some situations to find an appropriate regulatory role. To this end we are supportive of the concept advanced by the CBOT and the Chicago Mercantile Exchange to make the CFTC functions more supervisory, and to rely more on self-regulatory agencies.
This is not to say that CFTC's legal authority to respond to difficult circumstances should be diminished in any way, but rather that the agency should be less involved in day-to-day regulation and should not be writing contract market rules. That is the function of the exchanges.
To give clarity to cash commodity markets, we are recommending Congress consider changing the statutory language for cash forward exclusion from CFTC regulation. The clarifying language contained in our testimony states that a privately negotiated contract in which parties have a legal means to effect delivery or title transfer would be excluded from CFTC jurisdiction.
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We believe that these changes are in line with case law prior to 1996. We think that the CFTC should be investing more of its time in monitoring market changes such as international developments and over-the-counter activities that may affect the ability of markets to remain competitive.
The goal, in our view, should be to not only ensure that the U.S. exchanges are not disadvantaged in competing against near equivalent products but also that there are not inordinate barriers to entry created for potential new exchanges. Let fair competition govern behavior.
We would urge Congress to be careful not to create privileged groups in risk management. USDA research has shown that excessive subsidization of crop insurance, in particular products that contain a price protection component at relatively high price level equivalents, may create disincentives for farmers to use other price protection tools, such as cash contracts or exchange-traded instruments.
Such a program not only creates barriers to competition, it can also discourage early season marketing; and neither of these outcomes is desirable for the farmer or anyone else in the marketing chain.
Finally, we think that the time has come for the Government to give U.S. agriculture the risk management tools to truly succeed in a less regulated environment. Agricultural trade options can be an important tool in that mix, but CFTC's rules are much too burdensome.
At a March 10 public forum sponsored by the Senate Agriculture Committee, a panel of renowned experts agreed unanimously that the time has come to develop reasonable rules for agricultural trade options. We would ask that Congress give CFTC a clear sign of support for this tool through specific legislative language or direction to the agency to move forward quickly.
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We would also request serious consideration of legislative language stating that following the successful Trade Options Pilot Program, that regulations for ATOs become identical to trade options for other commodities and contracts. Agricultural trade options are cash contracts and should be regulated as such.
That concludes my testimony. I look forward to responding to questions.
Mr. EWING. Thank you, Mr. Keith.
[The prepared statement of Mr. Keith appears at the conclusion of the hearing.]
Mr. EWING. Before we go to the next witness, I want to recognize that David Spears is standing over there by the door. David is the new acting chairman of the CFTC. Congratulations and good luck. Mr. Roth.
STATEMENT OF DANIEL J. ROTH, VICE-PRESIDENT AND GENERAL COUNSEL, NATIONAL FUTURES ASSOCIATION
Mr. ROTH. Thank you, Mr. Chairman. I certainly appreciate the opportunity to appear here today and to share NFA's views on the very difficult issues which Congress is facing in the reauthorization process.
As I am sure it is obvious to all, the futures industry is undergoing a period of profound change, and ultimately it is up to Congress to ensure that the regulatory structure for the industry keeps pace with those changes in the industry itself. In order to do so, Congress has to realize that the changes that are taking place in the ongoing technological revolution is creating an environment in the market which is ever more globalized and ever more competitive.
Because the environment is more intensely competitive than ever before, it is more important than ever before that regulations operate as efficiently as possible. The rules that are overly burdensome or unduly burdensome were once an expensive nuisance, but now they are much more than that. They really threaten the vitality of the industry.
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At the same time, though, we have to recognize that we can't reduce regulatory burdens by engaging in a race to the bottom, and that really frames the basic issue that confronts Congress in this reauthorization, specifically,, I think, how to reduce regulatory burdens without reducing regulatory protections.
That is the thrust of the proposal put forward by the exchanges, and we certainly support the basic concepts underlying that proposal. Our perspective on that proposal is somewhat different. NFA is first and foremost a regulatory body. Unlike the exchanges, we do not operate a market. We don't engage in any sort of commercial activity and don't directly face the sorts of competitive issues that they do.
Regulation is all that we do at NFA. As a self-regulatory body, it is probably not surprising that, in our view, the way to reduce regulatory burdens without reducing regulatory protection is to enhance the role of self-regulation in the futures industry.
For 17 years NFA has taken on more and more responsibility from the commission, whether in the area of registration or ethics training requirements, or more recently in full disclosure documents and commodity trading disclosure documents. In each and every instance, we have been able to satisfy the demands of the industry that the regulation be performed with private-sector efficiency and at the same time satisfy the demands of the commission that regulation be done in a way that is both thorough and fair.
Self-regulation, in short, is a proven success story in the futures industry; and yet under the current structure, the role of self-regulation is under account in several ways. I think we all recognize that Government oversight is an essential component of the self-regulatory process. Government micromanagement is not.
Oversight becomes micromanagement when the commission doesn't tell us what to do, but tells us how to do it. The commission doesn't just set the regulatory standards that self-regulators have to meet, but mandates the specific procedures that we have to implement to meet those standards. I think the rule approval process is an example of that type of micromanagement.
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Virtually every rule that is adopted by a self-regulator, whether it is by the exchanges or by NFA, has to be approved by the commission. The commission has a very capable staff that works very diligently on the review and really conducts a line by line analysis and dissection of the rule. The result is really that the commission staff—and the commission, I think, is testing the rule to see whether they agree with it, whether they think that it is the most appropriate means of attacking that problem, whether they would do it the same way.
The result is a rule approval process that can take years, and the problem that NFA faces is certainly worse for the exchanges because for them it is getting new products to market, not just their new rules. We really feel that the commission's role is to monitor the self-regulatory organizations to ensure that they are fulfilling their statutory mandate and not to approve in advance the specific steps that they take to fulfill that mandate.
The current regulatory structure also undercuts self-regulation when it requires the CFTC to perform front-line regulatory responsibilities that can better be performed elsewhere, and we think the reparations program is an example of that.
The CFTC is the only financial Federal regulator to operate a dispute resolution program performed for customers. It was understandable why the reparations program was established back in the 1970's. Back then there were widespread boiler rooms in the industry, and customers were being victimized.
Furthermore, there was no NFA at that time and, therefore, no NFA arbitration program. But times have changed quite a bit, and now boiler rooms are largely a thing of the past due to the commission's and NFA's working together. Our arbitration program has grown, and the result is that filings in the reparations program have dropped by 80 percent since the NFA was created. We think the reparations program is a good program, but one which simply has outlived its usefulness. It is simply not a good use of commission resources to require them to operate a program which could be operated by the self-regulators with equal efficiency.
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Mr. Chairman, there is a myriad of issues that Congress will have to deal with in this reauthorization process, and we look forward to working with you and your staff and in helping in any way we can to resolve these issues and to perform any role that NFA can in providing the answer to the question of how to reduce regulatory burdens while preserving our regulatory protections. Thank you.
Mr. EWING. Thank you, Mr. Roth.
[The prepared statement of Mr. Roth appears at the conclusion of the hearing.]
Mr. EWING. Mr. Gaine.
STATEMENT OF JOHN G. GAINE, PRESIDENT, MANAGED FUNDS ASSOCIATION
Mr. GAINE. Mr. Chairman, members of the committee, I am Jack Gaine, president of the Managed Funds Association. We appreciate the opportunity to appear before you today. We commend you for your interest in ensuring that the Commodity Exchange Act remains vital and constructive in today's marketplace.
MFA's more than 700 members provide the various perspectives of alternative investment proposals, including hedge fund managers, commodity trading advisers, investment advisers, commodity pool operators, and fund of funds managers.
These professionals in the aggregate manage a significant amount of the nearly $300 billion invested in hedge funds and a vast majority of the over $35 billion invested in managed futures funds. MFA members trade in the over-the-counter markets, in domestic contract markets, on foreign markets, and in the cash markets. They are end-users of all markets affected by the CEA and CFTC regulations.
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Our members trade directly as customers for their own accounts as well as on behalf of their clients. In managing client accounts, a major component of competition for MFA members is based on the performance of those accounts. MFA members, therefore, have interests that are directly aligned with those of the ultimate customer on virtually all CEA regulatory issues.
Unnecessary regulatory costs of the exchanges and FCMs are ultimately borne by the customer, and we are dedicated to seeing those costs eliminated. However, our membership also suffers costs if markets lack integrity or efficiency.
Consequently, we support regulatory modernization and streamlining but believe that regulations essential to centralized market integrity must be preserved.
I will now turn briefly in an undisguised effort to win curry with you, Mr. Chairman and members of the subcommittee, just to a brief outline of my testimony which we will hopefully submit to the record. I will turn briefly to our views concerning several specific aspects of the current regulatory structure that we believe warrant consideration by the committee.
The Commodity Exchange Act modernization. In general and for the reasons I have briefly stated, MFA strongly supports this committee's review of the CEA to determine whether legislative changes are appropriate to modernize the CEA to meet the challenges of our highly competitive global marketplace.
In this connection, we congratulate the Chicago Mercantile Exchange and the Board of Trade of the city of Chicago on their development of a proposed conceptual framework to reshape the CEA and CFTC regulation to respond to the competitive and regulatory challenges presented by today's markets and those of the next millennium.
Today's highly competitive markets place a premium on the ability of exchanges and other market participants to respond efficiently and creatively to rapidly changing market developments both here and abroad, including new technologies, new products, and new trading and clearing mechanisms.
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MFA supports efforts to fashion a revised regulatory and self-regulatory structure that would expand the ability of futures exchanges to meet these challenges. Further, MFA believes that it is of utmost importance to the global competitiveness of the U.S. financial services sector to have a strong independent agency focused on fostering market integrity and efficient liquid markets at the lowest cost and the least possible interference with market and product innovation. MFA believes elimination of burdensome and costly regulation are necessary for the protection of professional participants in the market.
MFA believes that elimination of burdensome and costly regulation unnecessary for the protection of professional participants in the market benefits the marketplace, without detriment to the integrity of the market. FMA thus continues to advocate a two-tiered regulatory approach as a sound, proven approach to responsible regulatory streamlining.
Hedge fund and commodity pool issues. The President's Working Group on Financial Markets recently issued a study, ''Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management'' which addresses a number of topics of direct interest to MFA's members.
FMA also has just produced a paper on the same matters, Hedge Funds: Issues for Public Policy Makers. MFA testified before the House Banking Committee concerning the Working Group Report and will submit that testimony as well as MFA's policy paper for the record here. I will simply highlight MFA's views on several key points.
First, we agree with the working group that the most effective protection against events such as those involving LTCM is sound market discipline. Augmenting and reinforcing market discipline, therefore, should be the central concern of public policymakers.
Second, we agree with the working group that no additional direct regulation of hedge funds is warranted.
Third, MFA takes issue with the working group's recommendation for additional reporting by hedge funds to regulators and the public. We do not believe that the reporting envisioned by the working group addresses the issues raised by LTCM or serves the public interest.
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The working group's recommendations call for quarterly reporting of a snapshot of stale data which would not, in our view, provide any antidote to LTCM-type events and/or provide meaningful insights to regulators or the investing public concerning the operations of the reporting fund.
We thus seriously question the utility of such a requirement and note that a new requirement such as this is precisely the type of administrative burden and selective public dissemination of fund data which gives incentives to funds to avoid operating in the United States.
We note that Chairperson Born has testified that CFTC's staff are already preparing rules to implement the working group's recommendations on this point. We urge this committee to exercise its oversight authority to assure that no precipitous action is taken that will damage the competitiveness of the U.S.-managed funds marketplace.
Legal certainty. MFA supports efforts to give greater legal certainty to over-the-counter derivative products such as swaps, hybrid products, and foreign currency transactions.
The elimination of duplicative regulatory oversight of publicly offered commodity pools. Commodity pools are a significant and increasingly important part of the U.S. financial services industry. Organizational costs of such pools are substantial. A significant portion of these costs are attributable to the review process at the SEC and multiple States' security regulators and success given the comprehensive of the identify documents by the CFTC.
We ask this committee's support in our efforts to so avoid this duplicative regulatory jurisdiction. And let me conclude by saying we express our support for this committee's interest in modernizing the Commodity Exchange Act. We would be pleased to assist the committee in any way that it may find helpful during the conduct of its reauthorization hearings. Thank you for your attention.
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Mr. EWING. Thank you, Mr. Gaine.
[The prepared statement of Mr. Gaine appears at the conclusion of the hearing.]
Mr. EWING. Before we go on, Mr. Miller, we are going to have to make you wait, unfortunately. We will recess the committee for a few moments so we can all go and vote and then we will be back. Thank you.
[Recess.]
Mr. EWING. The hearing will come back to order.
Mr. Miller, thank you for waiting.
STATEMENT OF WILLIAM P. MILLER, CHAIRMAN, END-USERS OF DERIVATIVES COUNCIL OF THE TREASURY MANAGEMENT ASSOCIATION
Mr. MILLER. Good afternoon, and thank you for inviting the End-Users of Derivatives Association to testify here today.
At the time the invitation was extended, I was the chairman of EUDA. Now I am the chairman of the End-Users of Derivatives Council of TMA. As you may notice, we have grown a bit. With this merger, we now represent about 12,000 individual members at approximately 5,000 U.S. multinational firms. I am here today with Frank Curran of Treasury Management Association, and I would like to make a couple of points.
Our testimony includes results of a recent survey which emphasizes the importance of derivatives to our members. Derivatives are widely and extensively used to quickly and cost-effectively manage or hedge balance sheets, income and investment risks.
We are steady to growing users of derivatives in today's volatile markets. Our use runs the gamut and includes exchange traded and OTC forwards, swaps and options on foreign exchange interest rate equity, energy and other commodity products. We are significant users of derivative products that fall within the jurisdiction of this committee, as well as those that don't.
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We want minimal streamlined regulations that are not duplicative. Our survey also highlights that the ability to customize derivatives is very important to us. For exchange traded products, liquidity is very critical.
As end-users, we are responsible participants. Since the last survey, there has been a significant increase in documented procedures and the ability to regularly and independently value derivatives. We believe counterparty relationships are largely acceptable. A planned initiative of our merged organizations is to focus on measures for further improvements in this area.
Against this backdrop, our testimony is quite simple. First, remove legal uncertainty related to the status of OTC derivatives to remove the possibility of being considered as futures under the Commodity Exchange Act. There is a need for greater legal certainty concerning the status of OTC derivatives under the Commodity Exchange Act.
Once certainty is established, clearing, multilateral netting, antifraud and bankruptcy issues can be better addressed.
Second, there does not need to be a need for further regulation of OTC or exchange-traded derivatives. At this time, we are generally supportive of the recommendations from the President's Working Group on Financial Markets, ''On Hedge Funds Leveraged and the Lessons of Long Term Capital Management'' issued in April of this year.
Finally, as a guiding principle, any regulatory framework for OTC or exchange-traded derivatives should promote rather than discourage the development of standardized products and increased market transparency.
As end-users of derivatives, we favor a market environment in which a wide array of products is available to us and we can access these products as efficiently as possible. We believe that Congress now has before it an opportunity to promote the continued growth of such a market by modernizing certain aspects of the CEA as well as harmonizing it with other regulatory structures in the course of reauthorizing the CFTC. We appreciate the opportunity to present our views on these far-reaching and complex issues. Frank and I stand ready to respond to your questions. Thank you.
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[The prepared statement of Mr. Miller appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Miller; and since you are the last to testify, I will ask you the first question. In your testimony you are saying that you believe that the OTC derivatives should not be regulated, should be specifically exempted from regulation under this reauthorization, and that current regulation of that industry is sufficient?
Mr. MILLER. Yes.
Mr. EWING. Who do you consider to be your current regulator? I mean with the problems we had earlier.
Mr. MILLER. I think when we break that down into the type of instruments, for example, in the foreign exchange forward market, we are looking for the Fed in Treasury to be the responsible regulators in that area. I think in other areas we are looking at the SEC in regulatory parts as far as the security derivatives.
At this point we are not observing any gaps in the regulatory fabric that would cause us to come before you as a committee and propose additional regulatory oversight.
Mr. EWING. Well, that was the way I took it, and I wanted to clarify that because there have been those who have testified in these hearings and used the example of your industry to show how this, indeed, had fallen through the cracks as far as being detected by the regulators.
Mr. MILLER. I think in your opening comments you mentioned the aspect of reaching balance, and I think that has to be brought into play here in terms of how fine or how small do you make the net to catch everything from a regulatory efficiency perspective. There are things that are going to go through the net, and that will happen from an effective regulatory perspective.
Mr. EWING. The situation which arose in your industry was hardly a small one that fell through the net. If that had hit the floor and not been caught, we might have had a major disaster in our financial markets. You can't consider that was a small one that fell through the floor, can you?
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Mr. MILLER. I am going to assume that you are talking about Long Term Capital because otherwise we are going back to Proctor & Gamble and all of the other instances that we could go through in terms of there being breaks in the system.
Mr. EWING. Yes, Long Term Capital.
Mr. MILLER. I am going to just fall back to my personal position on that in this whole issue.
I believe that the regulatory structure should be such that regardless of the component of regulator, the regulatory body that is focusing on which component, that they should be working together in harmony so that they can pick up the issue that I call the overbooked airplane, so they can identify on a global basis when these pending problems are going to occur. And I think the report that came out of the President's working group highlighted the focus should be more on improving the counterparty monitoring and the banking monitoring of how credit is extended so as to not permit excessive leverage.
Mr. EWING. I thank you for that. I think it is certainly a part of the discussion that needs to be had, and the concern that many have—I think your statement certainly is your opinion and we are glad to have that and it is part of the debate here today as to which way we should go.
To all of you on the panel, to broaden this discussion between just Mr. Miller and I, how many of you believe that the agricultural futures and options require a different regulatory system? I think I picked up on that throughout the testimony of several of you, that we didn't need a dual system. Would any of you like to express yourself on that again? Mr. Keith.
Mr. KEITH. We think that the futures markets in general are very similar. There are some differences between traditional agricultural commodities and the financials and metals, but those differences are very slight compared to the differences between futures and securities and general stocks. So we don't see why they can't be regulated by one entity.
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Mr. EWING. Anyone else?
Mr. DYE. I was just going to say that even though there are similarities, there are differences; and I think it is in the fine-tuning of some of the definitions. But we would favor CFTC maintaining that oversight over both because we do feel the CFTC can focus on the agriculture issues; and we think that it is critically important that agriculture contracts don't get lost the monumental size of the financial futures versus the agriculture futures is real, and that is evident.
And yet the agriculture contracts have some real important implications that go all of the way back to the U.S. farmer and our whole food supply. We do think that it is important to keep that focus.
Mr. EWING. Thank you.
Mr. LAMBERT. Given the agricultural and the financials and metals are traded within the same exchange, in the interest of regulatory efficiency, it makes sense to have one regulatory agency with a consistent set of records-keeping over all of those futures and options contracts.
Mr. EWING. When we were debating this issue a year ago, there was some interest in the agriculture sector for a dual system, so we are not hearing that today, at least from this panel. Good.
Mr. Goode, do you have questions?
Mr. GOODE. Just a question of Mr. Miller. You are with Common Fund I believe you said in your statement?
Mr. MILLER. That is correct. It is a not-for-profit organization providing investment management services for colleges and university endowments.
Mr. GOODE. Say on a typical endowment portfolio for college or university, how much do they put in derivatives?
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Mr. MILLER. The investment framework—and I think the investment framework even on the pension side where I spent a significant amount of my time prior to the Common Fund—the assets are divided up by asset class such as equities, bonds, real estate venture.
It may even be traditional and nontraditional alternative investments. It is not allocated as a derivative for an investment. It is not looked at that way. Within those portfolios of equity, derivatives will be used, primarily equity derivatives and fixed; and we will use the bond futures to manage the duration and things like that. So it is not a separate asset class, but rather embedded within the asset classes that exist.
Mr. GOODE. Well, the colleges and universities, do they get involved in commodity futures?
Mr. MILLER. Yes, they do. As do pension funds. Pension funds are the predominantly used exchange-traded derivatives.
Mr. GOODE. Well, I know the Virginia retirement system used to have a—I think it was 70 percent bonds, 30 percent equities 20 years ago and that is about flipped now.
Mr. MILLER. Right. That is the Virginia retirement system as opposed to the college endowment. But they also had a managed futures account, I believe, as well that was well publicized.
Mr. GOODE. Back to your colleges and universities of your equities section, what percentage of that would be involved with futures or derivatives? Just a ballpark average.
Mr. MILLER. I would say a minimum 2 to 4 percent of the total assets in order to equitize what is considered frictional cash. It could be higher. I don't have any statistics on that.
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Mr. GOODE. It is just the individual managers or the firms make those decisions?
Mr. MILLER. As well as at the endowment level, they are used for tactical asset allocation purposes to temporarily change the mix from stocks to bonds.
Mr. GOODE. That is all that I have, Mr. Chairman. Thank you.
Mr. EWING. Mr. Gutknecht.
Mr. GUTKNECHT. Thank you, Mr. Chairman.
Mr. MILLER. Just to clarify if I could just for a minute.
Mr. EWING. Yes, Mr. Miller.
Mr. MILLER. I could take the position that we at the Common Fund have derivative programs that we offer endowments for several hundred million dollars in size, just to calibrate that for you.
Mr. EWING. Mr. Gutknecht.
Mr. GUTKNECHT. Thank you, Mr. Chairman. I want to sort of pursue what Representative Goode was talking about.
It hardly seems possible, but about 16 years ago I served on the pension commission for the State of Minnesota, and at that time we were moving in the same direction; we were moving from bonds into equities. How did we survive without all of these exotic derivatives? Anybody?
Mr. MILLER. The environment has changed so much in terms of the cost efficiencies associated with using derivatives. In today's environment it is more effective and we have moved to modern portfolio theory where we have moved towards diversification into these asset classes that you previously were not invested so heavily in, and as a result of having these derivatives, the ability to hedge the risk and to better manage it has allowed us to put greater assets into those asset classes.
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Mr. GUTKNECHT. Tell me a fund that better manages than the S&P 500 for the last 15 years? Using exotic derivatives, who has done a better job than the S&P 500? Name one.
Thank you, Mr. Chairman.
Mr. MILLER. I will provide that in writing if it helps. I am not sure—OK.
Mr. EWING. Mr. Riley.
Mr. RILEY. Thank you, Mr. Chairman.
Gentlemen, I am sorry I wasn't here for most of your testimony. Mr. Lambert, your testimony discusses a need for markets to operate in a reasonable manner free and clear of legal and illegal market abuse. Can you give me an example of what you mean by illegal or by legal market abuse?
Mr. LAMBERT. Legal market abuse would be in terms of information in equities or leverage position in equities where they are not really illegal activities; but they are, for a producer who may not have experience or information is at a disadvantage in the marketplace because of lack of information or lack of access to information.
Mr. RILEY. How could you address that?
Mr. LAMBERT. Primarily through educational programs that were raised in the testimony. In reality, sometimes there is no way to protect an individual from themselves if they are in a market where they are inexperienced or do not have that information.
Mr. RILEY. Mr. Miller, this may be remedial 101 on derivatives, but can you explain to me the difference between a derivative and a swap?
Mr. MILLER. A swap is a derivative. I can't describe the difference. It falls within the definition.
Mr. RILEY. I also serve on the Banking Committee, and there has been a lot of talk about derivatives and swaps and the ability for American business to be able to participate because of the lack of some sort of statutory regulations which allow you a legal justification to be in some of these.
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How much of these swaps and derivatives now are being forced overseas because we don't have that legal standing here that gives you the assurances that you need? Do you have any opinion?
Mr. MILLER. I am not sure that I have the answer to that.
Mr. RILEY. Would you say that it is a problem that may eventually, if we don't pass some legislation here, would cause more of these swaps, more of these derivatives, to move offshore or move into the European market?
Mr. MILLER. I think we have to be cautious. The point you are making is that it goes back to the complexities, and it can fall back to either tax issues, or it can fall back to regulatory issues that certain money managers have or corporations have in terms that restrict them.
If they are a multinational firm, the dealer that is providing these also is going to go to the environment where it is least costly to them and they have the flexibility to, when a multinational will engage in a swap transaction with a counterparty, that swap can be booked in the U.S. or it can be booked in their foreign locations. That is the point that you are getting at.
Mr. RILEY. I was thinking more about legal liability.
Mr. MILLER. What happens in a bankruptcy environment, that represents a counterparty exposure to our firms when they have to have a swap which is with Merrill Lynch in New York and one which is with Merrill Lynch in London, and we would like to have them all housed here under U.S. law where we are more comfortable as opposed to offshore.
Mr. RILEY. What percentage of the transactions that you are involved in now do you feel like are covered by some exchange, some commodity where you feel absolutely no legal liability as far as being a regulated swap or derivative?
Mr. MILLER. I have none that I am aware of.
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Mr. RILEY. What percentage of the swaps and derivatives that you are engaged in now are covered by an economic trading system such as the Chicago Board of Trade or another functional trading unit? Or are all of your swaps and derivatives actively traded on some board?
Mr. MILLER. No.
Mr. RILEY. What happens then of the ones that are not actively traded on a board? Do you feel any legal liability that you could be held liable for this because it is an unauthorized or an illegal trade?
Mr. MILLER. That is a legal question.
Mr. CURRAN. Sir, if I can go back to the prior question about percentage of transactions conducted on a structured exchange versus a nonstructured environment like over the counter, our survey work recently shows that at least in the environment of our members—400 organizations participated in the survey—and broadly about two-thirds of the transactions that they are involved in, derivatives transactions, are over the counter nonexchange traded.
Now, it differentiates by the purpose of the transaction for interest rate and foreign exchange hedges. They tend to be over-the-counter transactions, whereas in commodities transactions, they tend to be exchange traded. But that is kind of a broad breakdown which is based on the—it comes from the survey that we submitted with our statement, and I can't comment about the legal versus nonlegal environment.
Mr. MILLER. If I can take a stab at that question, I am not aware of any contracts that are exchange traded or swaps that are in legal question. In other words, our transactions with our counterparties, we currently believe, are in force legally.
What I think is the issue is that there is a perceived or a possible question of their legal viability when the issue comes up. Are they considered futures or are they swaps? And if they are futures, then perhaps they don't fall within that legal certainty framework.
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We would like legal certainty. We have legal contracts for our swaps out there. We assume that they are going to be enforced. We would pursue it that way. We have the cloud over us, though.
Mr. RILEY. Mr. Chairman, if I could pursue that.
Mr. EWING. We are being very lenient with time today.
Mr. RILEY. Thank you.
If you have a contract between two parties, legislation or the law says that they have to be covered as a swap, a derivative or as a commodity that is freely traded. At least in the testimony on the Banking Committee, there seemed to be a strong reluctance to enter into these contracts until there is a legal certainty that these contracts won't be challenged in court based on the validity of them being a swap or something that should be regulated by one of the exchanges. If I understand you right, that does not seem to be a problem.
Mr. MILLER. We also have our survey results which indicate that we continue to use them; our use is steady and growing.
Mr. CURRAN. For over-the-counter transactions, they run about two-thirds of the total volume and in posing other questions having to do with problems over the last 3 years in dealing with counterparties and meeting their obligations for over-the-counter transactions, there were virtually no problems. And the small percentage of problems that did exist were settled through arbitration.
So basically it has been a very healthy environment for over-the-counter derivatives transactions, at least through the last 3 years which the study addressed.
Mr. MILLER. And I would say that most of our derivatives are more along the lines of the vanilla as opposed to the exotic.
Mr. RILEY. Thank you, Mr. Chairman.
Mr. EWING. Mr. Pomeroy.
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Mr. POMEROY. Thank you, Mr. Chairman; and again I want to express my appreciation for the types of hearings that you have structured. I think the line of questioning shows that the members of your committee are really digging in, but it is tough stuff and I appreciate the way that we have been allowed to pursue ideas.
I think that one of the key issues that is emerging in my own mind is the appropriate relationship between formal traditional regulation and self-regulation, and there is much to be learned from the experience that is already out there.
Mr. Roth, your testimony references how the interplay is not always done well. Would you care to elaborate in terms of what we might do as a committee in fashioning legislation that would maybe clarify some of these issues going forward?
Mr. ROTH. The point that I made in my testimony, Mr. Pomeroy, is that self-regulation has a long history of success in the futures industry. But the current regulatory structure sometimes undercuts the role of the self-regulatory process, and I cite as an example the problems that arise when Government oversight becomes Government micromanagement; and to me that occurs when the CFTC doesn't simply set a regulatory standard for the self-regulators to meet but tries to dictate how they should meet that standard.
And in the rule approval process it is a situation where virtually every rule that either the exchanges or NFA adopts has to be approved by the CFTC, and very often that pre-approval process can stretch on for years. It is a very close and very analytical and dissection of a particular rule. And very often the tenor of the question seems to be if the commission agrees with the SRO in taking that approach.
And in our view, it would be better to have the oversight agency really focusing on the forest. Is the self-regulatory body meeting its statutory mandate and focusing on that larger picture rather than trying to scrutinize in advance each and every step that the self-regulator takes in order to meet that standard?
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Mr. POMEROY. Let us talk about the dimensions of confidence we might have in the SRO mechanism in the first place. I think that self-regulation has worked and can work. I think self-regulation has got to take as its premise that industry self-interest is an appropriate policing of the marketplace; that bad guys in the marketplace hurt the industry. Is it your view that is the predicate here?
Mr. ROTH. In my experience, yes, it is. It is really twofold. No. 1, bad guys in the business is bad for everybody. No. 2, I think it has been the premise behind self-regulation in the futures industry if we don't do the job right ourselves, then the Government is going to step in and do it for us and probably do it in a way that is less efficient and more burdensome.
So I think those are the two guiding forces that generate the self-interest on the part of the industry to regulate itself effectively.
Mr. POMEROY. Is there application that we might draw from the relationship between NASD and SEC that would have bearing or a specific example you would have us look to in terms of between CFTC and the SROs within the industry?
Mr. ROTH. I think there is a little bit of a tendency—with respect to harmonization of international regulation, our tendency is to say let us harmonize by letting everybody else do it our way.
I would suggest that the model to look at is not just within the United States and within the securities industry, but to look at what other international regulators have done. I know in the United Kingdom, although they have moved slightly away from self-regulation, I think there is more autonomy given to the self-regulatory bodies in the United Kingdom than there was here in the United States. Yes, you can look at the NASD and SEC model, but I think we ought to have broader horizons.
Mr. POMEROY. The U.K. model is just very generally a deregulated approach, which sometimes doesn't work that well. The near collapse of Lloyd's is an example where maybe there is too much dependence upon an SRO as opposed to external oversight, in my opinion.
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But I am going to direct the question to the Grain and Feed Council, and obviously the agriculutre community is going to be interested, aside from these arcane theories of regulation, which I happen to find really exciting, that shows how strange I am, but what the stakeholders think, and what does the Grain and Feed Council and the Grain Trade Council feel in terms of having your interests protected in an SRO environment as described by Mr. Roth?
Mr. DYE. Mr. Pomeroy, the self-regulation is fine from an overall perspective. We think that the oversight has to be there at the Federal level. There has to be safeguards against manipulation and fraud. I think it is important that the self-regulating organization itself has to have some accountability, and in the case of agriculture contracts, that goes beyond just the membership but to the users of the contract, the customer that is utilizing the contracts.
And it is important that there is accountability in there, and there is a venue for the user to be heard and to have input on how the process works. There may even be a way to look at certain levels of regulation and if it gets to be a certain level, that goes certainly to a broader authority. But beyond that, the smaller issues to get away from these micromanagement and duplication things, the SRO has full autonomy.
Mr. POMEROY. If Mr. Keith can answer, I have no other questions.
Mr. KEITH. We support a Federal regulatory structure that works well and allows innovation in the marketplace and is both policing of the marketplace behavior but also allows new products to develop that are needed in the marketplace. And to that extent we think that more flexibility needs to be encouraged and a little more free rein among the regulated community.
But we are most concerned that the CFTC recognize that there needs to be a balance among competing interests in the marketplace. Competitive forces can police marketplace behavior very well if allowed to do so.
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Mr. EWING. The next two gentlemen came in at the same time, so we will take seniority. Mr. Thune.
Mr. THUNE. Am I actually senior to someone around here, Mr. Chairman?
Mr. EWING. Well, I think you are to Mr. Walden.
Mr. THUNE. Well, that is nice to know. Sorry about that, Greg.
Thank you, Mr. Chairman; and I appreciate, members of the panel, for your being here today.
I would like to focus with some of the commodity groups and how producers view this whole subject. Traditionally, the role of futures exchanges has been to provide markets with price discovery and risk-shifting mechanisms; and it may be tied a little bit to what Mr. Lambert said, the whole issue of legal abuse.
Do you believe that the current regulatory structure protects against price manipulation? Is there a sense that the marketplace is subject to manipulation? Mr. Lambert, Mr. Keith, and Mr. Dye?
Mr. LAMBERT. I think from the beef industry standpoint, there is probably lack of knowledge builds distrust. There is a sector of the industry out there who doesn't use nor trust the futures markets. There is a perception that it is a game that is skewed against them. By and large from a regulatory standpoint, we do feel that the markets are not manipulated, but there is definitely that element of disunderstanding and distrust out there.
Mr. DYE. I think one of the challenges of the skepticism, if you will, out there is part of the unknown, but I think as we go forward, there are systems in place to create efficient regulation. One of the key things that needs to happen and needs to be consistent is making sure that there is a clear understanding of the economic factors that justify futures positions, particularly in expiring options where the cases of manipulations, as you suggest or are talking about, can come into play.
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And I think it is important that the self-regulating organization manage that closely, and again I think we have in place the tools today. The follow-up has to be there, though, with every expiration, and there needs to be a building of the confidence because today the user, the farmer today needs to use those tools more and more for their risk management, and it is very important that they have a comfort level with the self-regulating organizations.
Mr. THUNE. Do you think that given the fact that agricultural commodities only account for 9 percent of the futures contracts and 6 percent of options on futures—and Mr. Lambert you noted what you referred to as sort of a lack of knowledge, and my guess is from the folks that I talk to there is a lot of suspicions because if you are not working in this environment day in and day out, there is a lot of questions about how these things work, that there ought to be a separate sort of regulatory scheme. If you want to say something in that effect, for agricultural commodities that provides more safeguards, more protections? Again, agriculture is a small portion of the overall trading that is done. I am just wondering if your view is that there ought to be some sort of separate treatment for agricultural commodities.
Mr. DYE. My view is that, again, we can have a system if there is follow-up that is in place, and it can work for the agricultural commodities as well. What is important is having accountability to the users and ensuring that the systems are fair and are tested and are marked to build that confidence.
I don't think that we need more regulation or special regulation for the agriculture contracts, but I do think that it is critically important that we follow up and that the regulation is followed in a consistent manner.
Mr. THUNE. How do you address the lack of knowledge? I mean, right now in terms of your organizations?
Mr. DYE. Historically, there has been more Government subsidies which has lessened the need as much for risk management, certainly regardless of what the loan programs are, there still has been opportunity for other risk management uses for producers.
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And I think it is an evolution over time that as our marketplace changes, as we have volatility, as we have different farm bills and so forth, it is creating a heightened awareness. I think that education level is growing, and I think we are seeing some results from that. But it needs to happen more, in my view, and I think will over time.
Mr. THUNE. One thing I struggle with, we have the production side down, and the real challenge is marketing and how you go about ensuring that producers are well informed or better informed about the risk management tools that are available to them. Obviously, they are going to be in a much better situation if they are able to manage risk, and this is certainly one way of doing it.
Mr. Keith, you mentioned that you would advocate a more narrow definition of CFTC's legal authorities, and I am wondering if you believe that can be squared with protecting integrity and protecting customers and protecting the integrity of the market?
Mr. KEITH. We certainly think so. The situation that we have run into in the last few years, there have been some gray areas arising in the cash contracting. One of these is how do you define bona fide delivery in a cash contract. There was a court case involving a company in which the transaction of a paper—a warehouse receipts was brought into question as a viable form of delivery, and I think our industry had always been under the understanding that that was considered a viable delivery, warehouse receipts.
Our specific recommendation is to look at the cash forward exemption in the statute and see if there is some way to fine-tune that to at least clearly define what cash contracts are excluded from the jurisdiction of CFTC.
That does not mean that they are unregulated. There are a number of States that regulate cash contracting. It would be regulated by Uniform Commercial Code and other factors. Yes, we think that it can be accomplished.
Mr. THUNE. Thank you.
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Thank you, Mr. Chairman.
Mr. EWING. Yes. Mr. Thune, esteemed colleague that you are, I remind you that you are the senior member of the South Dakota delegation. If you are feeling without seniority.
Mr. THUNE. I will remember that the next time I have a delegation meeting, Mr. Chairman.
Mr. EWING. Mr. Bishop.
Mr. BISHOP. Let me just thank the witnesses for coming. I don't have any specific questions. I just want to make a comment or two, and that is what you do. Obviously, you are where the rubber meets the road where these issues are concerned, and I appreciate the time and the effort that you have made to come and make us aware and the continuing efforts on your part to make us aware of how you think that it could best work.
Using these tools day in and day out, of course, gives you the superior knowledge; and I want you to know that we are listening and appreciate it very, very much.
That said, I promise that I will continue to listen and as we develop legislation and as we work it through the process, we will try to the extent that we can employ your suggestions and resolve the apparent differences of opinion in ways that will hopefully be mutually beneficial to all.
With that, Mr. Chairman, I yield back the balance of my time.
Mr. EWING. Mr. Walden.
Mr. WALDEN. Thank you, Mr. Chairman. I just point out that I am the senior Republican member of the Oregon House delegation.
Mr. EWING. We have a lot of seniority here today.
Mr. WALDEN. I don't know who wants to address this, but it involves the agricultural trade options. In April 1998, I understand that the CFTC authorized a 3-year pilot program to allow agriculture trade options trading on and off exchange. However, after a year, no firm had applied to become an agricultural trade option merchant; and I am curious, why is the pilot program not working? Does anybody want to tackle that?
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Mr. KEITH. There are probably a number of reasons. One, the regulations are not in balance with the potential benefits, in particular, to the trade option providers. We think with some reasonable regulations that there will be an attraction to that program, but there has to be some clear benefits.
One of the primary problems with the program is that it did not allow cash settlements, which means that you can enter a trade option between an elevator and a farmer, and even if the farmer lost his entire crop, the law says that the elevator and the farmer cannot go back in and mutually agree to eliminate that former contact and to settle out, OK, for the balance of the remaining value of the contract.
So, in essence, while the trade option theoretically gave the farmer more flexibility, by that restriction, the agency took away all of the freedom that the contract allowed; and, therefore, it is not a very desirable product.
Mr. DYE. I would just add besides the regulatory structure, there has just been—the incentive to participate has been muddled by the fact that the registration process and a lot of the documentation behind record keeping and so forth, that has hurt the use or the interest in these products.
Going back to a point that Mr. Thune made on why producers are uncertain or don't use futures contracts, trade options would be a great vehicle for them to expand their risk management tools, but they need to be flexible and they need to be user friendly, if you will.
So they certainly have the right regulation around them that can be used, but that is the way that a farmer can work with a local elevator and work with somebody that they do business with on a regular basis and create different marketing vehicles and risk management tools utilizing futures and options, but not having to trade in those directly; and that is a vehicle that we certainly think can benefit a lot of farmers.
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Mr. WALDEN. Some of you have mentioned suggested changes such as the agriculture trade options pilot program. Do you believe any of these modifications will be adopted by the CFTC?
Mr. DYE. I think CFTC is undergoing review of that right now, and we have certainly stated the views that we have stated here today to the CFTC; and I know that they are reviewing them carefully, and we are optimistic that they will make some adjustments. We are hopeful.
Mr. WALDEN. And in this case, options are already allowed on the exchange.
Mr. DYE. It is another tool where the producer can deal directly with their local elevator and have somebody that they do business with regularly; and it will allow for a lot more flexibility and customizing specifically to a producer, whereas on an options contract, it is a pretty generic contract.
With a trade option, you can look at an individual situation and customize a price management tool that can benefit them individually. So based on that, yes, I think they will have some attraction.
Mr. KEITH. We think that it has some advantages that you can wrap a lot of protections within one contract to cover the basic risk and the logistics and marketing risks all in one contract which makes it more understandable to the farmer. They can understand the upside and the downside.
Mr. WALDEN. Thank you, Mr. Chairman.
Mr. EWING. Thank you. Mr. Dooley.
Mr. DOOLEY. No questions.
Mr. EWING. Mr. Roth, I liked your statement that we needed to limit the regulatory burden without limiting the regulations that protect the customers, and I think that sums up our goals here as we consider reauthorization. Would it be your belief that the current system is much too micromanaged, too slow, too cumbersome for today's modern, competitive world?
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Mr. ROTH. Essentially, yes, Mr. Chairman. I think the self-regulatory bodies by their nature are able to react more quickly to a quickly changing requirement; and I think that advantage of self-regulation can be greatly diminished every time you have to make a rule change you have to submit it to the commission for an approval process which can drag on for months or years.
So I do think that the self-regulatory bodies are not given enough autonomy, and that the benefits that are inherent in a self-regulatory body are diminished when they are subject to that sort of micromanagement.
Mr. EWING. Do you think that if we have a system that—where you don't have to have all of the prior approvals and you don't have to jump through all of the hoops that we do today, that it certainly will speed up and probably enhance competitiveness, would you agree?
Mr. ROTH. Yes, sir.
Mr. EWING. The question is how much security and safety do we lose?
Mr. ROTH. Well, that is the question. In our view you wouldn't lose much because of several points. One, just as Mr. Pomeroy was pointing out earlier, there is a strong interest on the part of the self-regulators to make sure that they get their job done right.
No. 2, I think there is still an important oversight role for the Government to perform, and the Government under the sort of situation that we are envisioning would very much hold the self-regulators accountable to fulfilling their statutory standards. They simply wouldn't try to preapprove every step that they take to do so. But if a self-regulatory body fails to fulfill its regulatory objectives, it should very well and must be held accountable to the commission.
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Mr. EWING. Mr. Lambert, you are listed as representing the Agriculture Producer Coalition, and it would seem that when we are talking about a two-tier system, that some of the agricultural groups have changed their opinion since we discussed this in the last Congress reauthorization bill that was introduced then; that they thought that there should be—not a pearl market, the pearl market was the system that we were talking about then, the agriculture groups were not in favor of that generally. Would you comment on that and how we can move to this self-regulated, not-having-prior-approval-type system and how that may play with the agricultural groups?
Mr. LAMBERT. It is not to say that there are not some members of the coalition who would still not favor a two-tier system. By and large our position is that one regulatory system is more efficient from a regulatory standpoint, and having two regulatory bodies on the same exchange is duplicative and increases the cost of regulatory compliance.
With respect to the—I am sorry. I forgot the second part of the question.
Mr. EWING. We were talking pro-market last time and the agricultural groups didn't want to give up the more structured regulatory system that we currently have, and I am wondering if there was a change, and you didn't cover that in your testimony.
Mr. LAMBERT. The organization still supports CFTC as the sole regulatory body. There were some concerns that the pearl market would be split off under other regulatory bodies, and we still support CFTC as the sole regulatory body of futures and options exchanges.
Mr. EWING. Would your group, do you think, support a CFTC that had more oversight responsibility without the responsibility of prior approval of every contract and dotting every I and crossing every T before the industry actually took part in some new contract or venture?
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Mr. LAMBERT. I think the producer groups are willing to consider increased self-regulation. Encompassed in that would need to be some type of flexibility to allow increased—other exchanges to come in, increased competition, alternatives in risk management so that in the instance where the self-regulator failed in their—to offer the protections so that there would be an alternative, the competition would enhance the ability of the self-regulators or—or the incentive for the self-regulators to take those regulatory actions.
Mr. EWING. To anyone on the panel, I don't remember hearing a comment from constituents that the over-the-counter market or the stock market or the foreign exchange market was manipulated. Now, maybe I don't run in those circles, but I can tell you that every once in a while I have an agricultural producer who believes that the markets are all rigged.
What do we do to create that more secure feeling about their markets? I mean, if commodity prices are not necessarily the Board of Trade's responsibility, they reflect the market, that is what they are supposed to do. Do you run into this with the people in your organizations and the people you deal with? And if we go to a different system of regulation, do we build more skepticism or do we build more confidence in the market?
Mr. DYE. I think we need to attempt to build more confidence and use this as an opportunity to attempt to do just that. There have been a couple of instances over time that have created some of those feelings of distrust, but I think it is a process of education and awareness. And as we get into a new regulatory structure and go more towards self-regulation, that is why I think it is so important to have some accountability measures built in, to have a process that there is input and feedback from the producer groups and others who are reliant on the exchanges.
Mr. EWING. Anyone else? Mr. Keith.
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Mr. KEITH. Maybe it would be helpful if the CFTC could make more public its own review process that it watches the marketplace with to build some confidence because they get detailed reports from large traders.
It is not just large hedgers. They are very significant speculators, and there are many safeguards against manipulation. But still the CFTC has to be a competent agency, and it has to have competent people watching and understanding how to prevent such abuses.
Mr. EWING. Anyone else?
Would you today vote that the CFTC operates in an inefficient and ineffective manner, and maybe that is not the right way—that maybe they are too cumbersome in their approach to regulation and it takes too long? Do you think that is a hindrance to the industry? Who is brave enough?
Mr. GAINE. Yes, from our point of view, there is an awful lot of delay generally built into any regulatory action which I think some of the proposals which have been kicked around would minimize the up-front involvement of the CFTC which should serve, particularly in the designated contract market process, should serve to move things along very rapidly.
Yesterday, the commission took a major step forward, I think, in approving an advisory which permits exchanges to come in and ask for block trading authority. This is something we have been very interested in, the managed funds area, the ability to do large trades, not in the pit in the normal way.
The advisory came out yesterday. It has been kicking around for years and years and years. But regulatory delay is a major problem. I think the exchanges probably see it day in and day out.
Mr. EWING. Yes, Mr. Miller.
Mr. MILLER. From the end-user financial market perspective, I think we have very good regulatory structure here. We have a lot of confidence in our regulators. I think it serves as a model for the rest of the world. Is it perfect? No.
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I think that we are finding ourselves in an environment where—in an OTC environment a product can be delivered to us and we can execute on that product within a matter of days. That same kind of product on the exchange traded basis, if it is new, it is going to have to go through a much lengthier process and is not available to us.
We, therefore, would move towards the OTC product on that kind of a basis. What we are interested in as part of our testimony is to have products readily available to us in any environment.
Mr. EWING. Do any of the other members have other questions?
Mr. RILEY. Mr. Chairman, if you would expand on that statement just a little for me because I think what I heard you say is basically you would like to move the Government or regulatory bodies out of this process?
Mr. MILLER. Not out of the process, but rather a different type of model. Regulatory oversight serves a very useful role in antifraud, antimanipulation, things like that. But it shouldn't be used in a fashion that delays competitive products from being brought to the market.
Mr. RILEY. If you will take it one step further and give me a specific instance of a specific product that you would have a delay on because of a Government regulation?
Mr. MILLER. The Russell 2000 contract took approximately 2 years to be developed. Actually, now that rests with CFTC. Some of that rests with persuading the market environment to list the contract, put it on the market and the like—or on the exchange. And even when, just to put things in perspective, the CFTC had accelerated that process, I think that went through rather quickly. I think the NASDAQ 100 was another example. That took a long time.
What would be nice is to be able to say this is a contract there is demand for. We can offer it through the exchange. You can walk into the end-user and say we can offer this through the exchange; here is what it is. You can trade it tomorrow. We can run it through the exchange tomorrow.
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Mr. RILEY. What would the downside of that be? I don't see one.
Mr. MILLER. Well, if you look at the history of the exchanges and the regulatory structure, it has matured quite a bit over the years where I think there is a high degree of comfort from the large, sophisticated users with the exchanges so I don't think that we would see a downside either.
Mr. RILEY. Are there any agricultural products?
Mr. MILLER. We do draw the line there and our focus is primarily on the financials. The financial market environment has changed also. I think the speculative position limits don't exist on the Capon contract or the Eurodollar or the S&P.
You have the financial responsibility requirement associated with the positions that you have. That makes a lot of sense for the financials. I am not sure that it makes sense for the agriculturals, but that is not my area of expertise.
Mr. RILEY. Would any of you have a comment on that? We had a discussion up here about why do we have so many products available today that could be used in a hedge or in a swap, but only a very limited few are actually traded on a commodity exchange. Do we need to expand on that? Do we need to reduce it?
Mr. KEITH. I think we do need to be careful in the agricultural arena of how we regulate things. As an example, CFTC's trade options' rules make a comment about agriculture swaps, saying that the exemption that had been in place for swap transactions of $1 million can no longer be relied on; and now the new exemption level is $10 million.
And what that did was put a chilling effect on the agriculture swaps marketplace which was not huge, but it was growing and developing. In particular, there were some financial institutions and some farm management companies that were using swaps actively because of their ability to manage risks at multiple locations throughout the country as one entity as opposed to hedging the commodities at individual locations through a central management function.
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They outsourced that through a swap transaction, and those types of activities have been curtailed by a poorly written rule, the CFTC Trade Option Program, unintended, by the way.
Mr. RILEY. How many different agricultural products would you say fall in that category?
Mr. KEITH. Well, any of the agricultural commodities theoretically could be hedged or the risk being managed through swaps or trade options, or what some people would call forms of derivatives; but they are actually specific definitions of derivatives.
Mr. RILEY. Thank you, Mr. Chairman.
Mr. EWING. Thank you. If there are no other questions, I would like to thank the panel and all of the witnesses for your time and effort for appearing here today. I think it has been a meaningful experience for us and I hope for you. The record will stay open for 10 days to accept statements and any additional information which you may wish to submit. And with that the committee is adjourned.
[Whereupon, at 3:07 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
Statement of Chuck Lambert
Thank you Chairman Ewing and members of the subcommittee for holding hearings regarding risk management and regulatory reform issues. NCBA commends your continuing efforts to improve risk management alternatives during this time of volatile prices for most U.S. agricultural products. I am Chuck Lambert, chief economist for the National Cattlemen's Beef Association.
I should state at the outset that NCBA is part of a broader agricultural coalition working on a wide range of issues related to CFTC reauthorization and futures market issues including off-exchange agricultural trade options. A letter from the coalition cosigned by coalition members including NCBA will also be submitted for the record.
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Situation Analysis: NCBA encourages individual producers to study all marketing and risk management opportunities available to them and to choose those best suited to their individual needs. We support continued innovation and improvement of marketing alternatives and risk management tools for producers. NCBA supports the competitive free market system in the beef business and increased competition in the marketplace.
Beef producers suffered huge losses in recent years. Cattle prices plummeted during1996 as a result of record high feed grain prices and increasing beef production. Beef production levels remained at record levels during 1997 and 1998 while feed grain prices declined and price levels adjusted accordingly. Risk management has become absolutely critical to survival within the livestock industry as price volatility has increased in livestock markets and feed grain markets, our primary purchased input besides feeder cattle.
Only 4 percent of the world's population live in the United States. Population demographics clearly indicate that America in general, and American agriculture specifically, need to aggressively seize opportunities to market products in countries with young, fast-growing populations that have increasing disposable incomes. Increased reliance on export markets is a reality as U.S. agriculture looks globally to expand demand for U.S. commodities. However, increased reliance on export markets interjects additional market uncertainty and price volatility as events related to the Asian financial crisis during the last 2 years has painfully demonstrated. Commodity futures markets and other risk management tools are now more critical than ever before.
Beef producers will require more alternatives to protect themselves from increased global price volatility. Demand will increase especially for risk management products that offer improved market transparency, reduced trading fees, and the perception of market integrity that sometimes is lacking within the current risk management alternatives.
The rapid development of computer software and the growing importance of the Internet are revolutionizing the way many stocks and bonds are traded. Futures markets are not likely to be exempt from these competitive pressures.
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Regulatory Authority: Trading of commodities through futures markets influences prices for cattle, feed grains and competing meats including hogs and pork bellies. It is absolutely imperative that all markets operate in a responsible manner, free and clear of legal and illegal market abuse. To achieve this result NCBA strongly supports the following regulatory and educational activities:
Law and Compliance - Protect the integrity of agricultural futures markets and the cattlemen who choose to use those markets. Enforce existing laws and increase compliance with regulations of the Commodity Futures Trading Commission (CFTC), the National Futures Association, the Chicago Mercantile Exchange (CME), the Chicago Board of Trade and the Mid-America Commodity Exchange.
Exclusivity - Maintain the CFTC as the independent and autonomous regulatory agency of the commodity futures and options trading industry and maintain agency reauthorization. Although we support exclusivity, many in U.S. agriculture are concerned about recent CFTC initiatives to expand regulatory authority beyond its current scope of responsibility. These initiatives have detracted from regulatory effectiveness and CFTC is urged to focus future regulatory efforts within current authorization limitations.
Margin Authority - Maintain authority of commodity exchanges to have explicit front-line responsibility for setting initial and maintenance margin requirements for futures and options contracts with improved CFTC oversight.
Large Trader Reports - Require CFTC and CME to provide more detailed accounts of large trader commitments on a weekly basis. Include a breakdown of long and short positions by contract month held by producers, packers, and commodity funds in addition to the traditional breakdowns of commercial and non-commercial positions.
Cross Hedging - NCBA urges that no cross hedge exemptions be granted by the CME in excess of speculative limits for the purpose of hedging feeder cattle in the CME Live Cattle spot month contract.
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Industry Input - NCBA will oppose any legislation that does not allow an opportunity for input from the cattle industry on futures contract changes
Educational Activity - Coordinate with various groups to develop and initiate comprehensive programs for beef producers not only on the mechanics of commodity futures and options markets, but also on the application of those risk management tools to individual operations and management objectives. And,
Market Research - Increase interest of Government and private agencies, along with universities, to allocate resources for basic commodity market research. Encourage development of new risk management products including cash settled live cattle futures contracts, wholesale boxed beef futures and options contracts, retail beef futures and options contracts and heifer delivery if the CME Live Cattle Contract remains a delivery contract.
Need for Competing Risk Management Alternatives: The selection of risk management tools in the form of futures and options contracts available within most agricultural commodities is limited, in most cases, to one contract per commodity. For example, in the case of fed cattle, the CME Live Cattle futures and options contracts are the only risk management tools available.
Futures contract specifications for those tools must be consistent with the underlying physical commodity for the contracts to be viable risk management tools. In the absence of free market competition and market alternatives, commodity groups have been forced to rely on negotiation with commodity exchanges and regulation of contract specifications to provide the best risk management tools possible for their members. These efforts have often fallen on deaf ears.
Interests of the legitimate producers of the underlying physical commodity are often ignored in favor of the floor traders who serve on the contract committees at the exchanges and more often than not have a vested interest in the status quo. Frustration and distrust among many major cattle feeders regarding the incestuous nature of exchange politics has hastened the move to contractual integration in the cash market as a risk management alternative to the use of futures and options markets.
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FutureCom applied to the CFTC to become an Internet-based futures exchange as an alternative to current futures markets. If approved, FutureCom participants could actually trade contracts electronically, directly on the Internet rather than through an intermediary. Notice of FutureCom's application was initially published under delegated authority for public comment nearly 2 1/2 years ago on January 31, 1997 (62 FR 4730). FutureCom was not previously approved by the CFTC as a contract market in any commodity. Therefore, in addition to the terms and conditions of the proposedfutures and options contracts, FutureCom has also been required to meet the requirements for a board of trade seeking initial designation as a contract market.
Congress recognized the importance of speedy and responsive regulatory oversight when they instructed the CFTC to limit their review on new applications for contract markets to one year. While FutureCom represents a major change in the way risk management tools have traditionally been transacted, electronic trading is part of the future. Even with the above-mentioned complexities it would seem that the 2 1/2 years taken to date for CFTC to grant approval of this innovative concept (and it still has not been approved) is excessive.
Many legitimate hedgers of fed cattle have complained that the current live cattle contract is not a viable risk management tool because of basis unpredictability. Many futures contracts are cash settled, but the current live cattle contract continues to rely on physical delivery. There is an interest, but not consensus, throughout the beef industry for cash settlement of the CME live cattle contract and the industry has requested that either heifers be allowed for physical delivery or that the contract be cash settled. Neither request has been granted.
FutureCom has proposed trading a cash-settled live cattle contract. Approval of the FutureCom contract would allow producer preferences to be reflected through the competitive free market system for risk management alternatives. As a cash-settled contract, the FutureCom live cattle contract might also mitigate industry concerns about the lack of delivery points outside the plains feeding region. FutureCom approval would allow producer preferences for risk management tools to be reflected through the competitive marketplace and use of the respective competing contracts.
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FutureCom would provide an alternative risk management tool for bona fide cattle producers and could address many other concerns that have been raised with the existing contract.
FutureCom proposes to utilize state-of-the-art electronic technologies that will lower transaction costs, assure trading integrity and enhance transparent price discovery. As an electronic exchange, FutureCom would address many other long-standing NCBA policy objectives including accurate electronic records and provide an instantaneous, electronic, verifiable audit tail.
Need for Regulatory Flexibility: Based on the FutureCom experience and the CFTC's failed experiment with the Agricultural Trade Options pilot program, increased regulatory flexibility is crucial for the survival of creative and visionary entrepreneurs within industry. It is critical that the CFTC have the authorization be innovative and flexible from a regulatory standpoint. Congress is encouraged to work with industry and the CFTC in determining how much flexibility the Commission needs to address the changing technological environment. Given this regulatory agility, the CFTC can encourage, and not impede, those who think outside of the traditional box.
The intense interest in electronic trading is fueled by two issues: (1) rapidly increasing globalization of the futures and options markets in particular—and financial markets in general; and (2) tremendous advances in electronic trading technologies and activity.
The lower transaction costs and the inherent benefits regarding oversight of electronic trading systems make them an attractive complement, or alternative to, traditional trading methods. However, at the time of the promulgation of the Act and regulations, it obviously was not possible to contemplate the incredible advances in the way markets today effect transactions and conduct business. Congress is encouraged to take a comprehensive look at the Act with an eye toward making amendments to accommodate changes related to electronic trading.
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For example, provisions relating to designation of a completely electronic exchange should be reviewed. Also, the movement to electronic trading systems may have an effect on the design of exchange governance systems—and the current law envisions designation of traditional membership exchanges as opposed to proprietary exchanges. These issues deserve Congressional attention during the reauthorization process.
The National Cattlemen's Beef Association appreciates the initiatives that have been undertaken to maintain and improve risk management tools for agriculture. NCBA is prepared to participate in the process of evaluating critical risk management issues within the beef industry. NCBA looks forward to providing additional input as other marketing issues are addressed, including price reporting, labeling and a host of trade issues including accession of China to the WTO, access issues with the European Union and authority for negotiating additional trade agreements. Thank you for the opportunity to present this information.
Statement of William P. Miller, II
Good afternoon, Mr. Chairman and members of the subcommittee on Risk Management, Research and Specialty Crops, of the Committee on Agriculture. I am William P. Miller, senior vice-president and Independent Risk Officer of Commonfund, which provides investment management services for educational institutions. I was Chairman of the Board of the End-Users of Derivatives Association (EUDA) at the time you invited us to testify and today I am honored to offer this statement on behalf of the newly created End-Users of Derivatives Council of the Treasury Management Association (TMA).
Founded in 1994, EUDA has represented over sixty organizations that use derivatives to manage risk, and has been in the forefront of end-user development in the derivatives market since its inception.
TMA represents about 12,000 treasury professionals who, on behalf of over 5,000 corporations and other organizations, are significant participants in the nation's payment systems and capital markets. Many members are responsible for their organization's derivatives activities with the primary objective of risk management. Organizations represented by members are drawn generally from the Fortune 1000 and the largest of the middle market companies, and they have an active interest and sizable stake in any regulatory and put legislative changes affecting usage of derivatives.
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Effective June 1st of this year, our organizations have merged to form the End-Users of Derivatives Council of TMA, the pre-eminent professional organization for end-users of derivatives.
Today, I am accompanied by Frank Curran, Vice President for Government Relations and Technical Services for TMA.
Our statement addresses the reauthorization of the Commodity Futures Trading Commission and the ramifications of the CFTC's role in regulating segments of the derivatives market. We also offer our thoughts on the need for changes to the Commodity Exchange Act in order to:
Bring greater certainty to the derivatives market;
Reduce or eliminate obstacles to the development of new products and new ways of accessing these products;
Promote the development of facilities that will enhance liquidity and transparency while reducing counterparty risk exposure.
As background to this critical discussion, we offer the subcommittee the yet unpublished results of a 1999 survey of derivatives use and risk management practices conducted by TMA. We will summarize the highlighted conclusions of the study, and have attached the complete report to this statement. The survey was conducted for TMA by the National Economic Research Associates (NERA).
TMA has drawn upon its unique membership base - individuals engaged in the treasury profession at a wide range of organizations such as publicly and privately held corporations, governmental units and other non-profit institutions - to provide a broad perspective on important and timely issues surrounding the use of derivatives.
Like the original 1995 survey, the current research survey addresses the full spectrum of derivatives, including both OTC and exchange-traded derivative contracts and derivative securities. The current survey places more focus on the use of OTC derivatives in order to address issues involving risk management practices, counterparty relationships, new accounting and disclosure requirements, and proposals for additional regulation.
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While the full report contains an extensive analysis of the survey data, the important highlights are summarized below.
USE OF DERIVATIVES
Derivatives are widely used, with 63 percent of all respondents indicating that they use derivatives for risk management or hedging, in conjunction with obtaining funding, or for investment and trading. For large organizations, 78 percent used derivatives.
Derivatives are primarily used for risk management or hedging (86 percent of all users), compared to other uses such as obtaining funding (40 percent) or investment and trading (19 percent).
The widespread volatility in financial markets in 1998 did not lead to a reduction in the overall use of derivatives. In fact, roughly 80 percent of the respondents reported either no change or an increase in derivatives use.
CHOICE OF DERIVATIVES
For managing foreign exchange exposures, OTC forwards, OTC swaps and OTC options are ranked among the top three instruments in terms of importance by 80 percent, 35 percent, and 36 percent of respondents respectively. Less than 7 percent of respondents included exchange traded futures and options in the list of the top three instruments.
For managing interest rate exposures, OTC swaps, OTC options, and OTC forwards are ranked among the top three instruments in terms of importance by 69 percent, 29 percent, and 27 percent of respondents respectively. Slightly more than 12 percent included exchange traded futures in the list of the top three instruments.
For managing commodity price exposures, exchange traded futures were ranked among the top three by 39 percent with the rest, including exchange traded options, OTC swaps, OTC forwards, and OTC options, being mentioned by 19 percent to 27 percent of the respondents.
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Of those respondents using OTC derivatives, 63 percent indicated that the ability to customize transactions to specific needs was one of the most important factors affecting their decision to use OTC derivatives.
Of those respondents using exchange traded derivatives, 83 percent ranked market liquidity as one of the most important factors in their decision to use exchange traded derivatives.
RISK MANAGEMENT PRACTICES
Nearly 80 percent of respondents reported having documented policies and objectives governing the use of derivatives, that clearly define the purposes for which derivative transactions can be undertaken, that are approved by the board of directors, and that are implemented through approved procedures and controls.
Over 95 percent of the respondents have the means, either internally or through independent third-party sources, to value their existing derivatives exposure. In terms of measuring market and credit risk, over 90 percent have the means, internally or externally, to measure market risk; 84 percent have the means to measure current credit exposure; and 79 percent have the means to measure potential credit exposure.
Over half of the organizations value their derivatives portfolio on a monthly or more frequent basis, 19 percent on a quarterly basis, and 23 percent on an as needed basis.
COUNTERPARTY RELATIONSHIPS
Over 95 percent of the respondents have the means, either internally or through independent third-party sources, to assess the appropriateness of potential derivatives transactions and determine their associated risks.
Commercial banks were a primary source of derivatives transactions for 82 percent of the derivatives users, followed by investment banks (38 percent) and exchanges (13 percent).
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Over the last 3 years, none of the respondents experienced default on a derivatives contract by a counterparty.
On an overall basis, 89 percent of the respondents were satisfied with the relationship they had with their OTC derivatives dealer. Only 2 percent reported dissatisfaction, despite 5 percent reporting having a dispute with their dealer in the last 3 years. Almost all these disputes were resolved through negotiation.
ACCOUNTING AND DISCLOSURE
While 56 percent of respondents thought FAS133 would have no impact on their organization's hedging activities, the others who responded indicated that it would affect either the extent (19 percent) or timing (15 percent) of their hedging transactions or their choice of hedging instruments (19 percent).
A majority of respondents (60 percent) thought that the compliance costs of FAS133 would be material or substantial.
REGULATION
Of all respondents using derivatives, 75 percent do not believe additional Federal regulation of the OTC derivatives activities of dealers and end-users is necessary. Only 10 percent of the respondents believe additional Federal anti-fraud enforcement of OTC derivatives activity is necessary.
Privately and publicly held firms were much less likely to believe that additional Federal regulation is necessary than were users from the governmental and non-profit category.
The overall objective of our newly merged organization is to encourage the continued development of an efficient and liquid market for end-users for a variety of exchange-traded and over-the-counter (OTC) derivative products by taking actions to promote:
Increased understanding of derivatives and their use;
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Reduced legal and other risks for end-users of derivative products; and
Development of a legal and regulatory environment which is conducive to the appropriate and prudent use of derivatives.
Our members have long recognized the value and importance of derivatives. In a worldwide economy, where the volatility of interest rates, currency exchange rates, and commodity and equity prices pose significant risks for a wide variety of business entities, derivatives have become essential risk management and investment tools. For many financial institutions and other types of corporations, the prudent use of derivatives offers a cost-effective means to manage those financial risks, which can have a material effect on their balance sheet, income and cash flows. Investment managers properly use derivatives to manage portfolio diversification, duration, liquidity, and cash flows. In the absence of derivatives, these risk management activities would be more costly, and in some instances, would be impossible to undertake.
Our members also recognize that while derivatives are an important tool in the management of financial risks, their use can also pose risks. Accordingly, we have examined a number of situations where the use of derivatives has resulted in unanticipated losses. We have sought to further discussions among end-users on how to curtail or eliminate such mishaps.
There is a need for greater legal certainty concerning the status of OTC derivatives under the CEA.
Much of the legal uncertainty that currently exists in the swap market results from a combination of two factors: (1) attempts to craft exemptions from regulation under the CEA without first determining whether swaps are actually subject to such regulation; and (2) the legal prohibition against off-exchange transactions in futures that are not otherwise exempted. This leaves swaps that fall outside the scope of the exemptions (whether because of the terms of the exemptions themselves, or because of limitations on the CFTC's authority to grant such exemptions) in a state of legal uncertainty. A possible solution to this legal uncertainty would be either: (1) to determine unequivocally that swaps are not covered by the CEA or (2) to provide that the prohibition against off-exchange transactions does not apply to swaps even if they are considered to be futures. Such an approach would eliminate the need for endless tinkering with the terms of the existing exemptions as the market continues to evolve.
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There does not appear to be a need for further regulation of OTC derivatives.
Many participants in the swap market are already subject to regulatory oversight involving their derivatives activities. Moreover, based on the survey results we offer with this statement, as well as the results of the General Accounting Office's 1998 study of sales practices for OTC derivatives, it does not appear that the swap market has experienced problems concerning fraud or sales practice abuses to an extent sufficient to warrant regulatory intervention. There may be a need for improvement in dealer/end-user relationships, which have at times been characterized by efforts on the part of the dealer community to define the terms of such relationships unilaterally. For now, however, these issues would seem to be best addressed through ongoing discussions between dealers and end-users.
In general, end-users have become more sophisticated in their risk management skills over the past several years. Part of this elevated focus on risk management is the result of more stringent oversight by bank and other industry regulators. Even for non-regulated end-users however, isolated but high profile cases involving substantial losses have focused greater attention by risk management staff on OTC derivatives activities. As a result, many end-users have enhanced their internal management and control systems.
We recognize that not all end-users possess the same level of sophistication. On the one hand, a growing number of end-users either have internal systems along with highly trained staff allowing them to model OTC derivatives themselves, or have sought independent outside assistance in performing this function. On the other hand, there are still large numbers of end-users that are less sophisticated and that continue to rely on the dealer community for information regarding the fair value of and risks associated with OTC derivatives.
Nevertheless, we do not believe it is in the best interests of end-users to create more stringent rules for the OTC derivatives market to provide additional protection for the less sophisticated end-user. The OTC derivatives market is and should be one in which both dealers and end-users are ready and willing to assume responsibility for their own activities. It does not seem appropriate to introduce regulatory protections as a way of encouraging or facilitating participation in this market by entities that otherwise may not be fully prepared to assume this responsibility. In addition, to apply more stringent standards of conduct based on the sophistication level of the end-user would be counter-productive to the growth of the derivatives market and would impose a difficult burden on dealers. This burden would inject unnecessary additional costs into each OTC derivatives transaction. It may also reduce the willingness of dealers to create new types of products that are needed by more sophisticated end-users. For these reasons, no new regulation of the OTC market appears to be warranted at this time.
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Any regulatory framework for OTC derivatives should promote, rather than discourage, the development of standardized products and increased market transparency.
To address the needs of less sophisticated end-users, any regulatory framework for OTC derivatives should promote, rather than discourage, the development of facilities for the execution of standardized transactions in a manner that enhances market transparency and reduces counterparty risk exposures. This would include taking steps to reduce or eliminate existing regulatory impediments to the development of clearing facilities, multilateral transaction execution facilities or other arrangements that might promote increased liquidity and price transparency in the swap market. Many of the concerns that have been raised about the swap market could be addressed more efficiently by taking such steps than by devoting continued attention to the definition of eligible participants or to the regulation of sales practices and related matters.
SUMMARY
As end-users of derivatives, we favor a market environment in which a wide array of products is available to us, and in which we can access these products as efficiently as possible. We believe that Congress now has before it an opportunity to promote the continued growth of such a market by modernizing certain aspects of the Commodity Exchange Act in the course of reauthorizing the Commodity Futures Trading Commission. Specifically, we support changes in the Commodity Exchange Act that would:
establish legal certainty concerning the status of OTC derivatives;
reduce or eliminate obstacles to the development of new products and new ways of accessing these products; and
promote the development of facilities that will enhance liquidity and transparency while reducing counterparty risk exposures.
We do not believe that any additional regulation of the derivatives market is warranted at this time. We appreciate the opportunity to present our views on these far-reaching and complex issues.
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Statement of Daniel P. Dye
Mr. Chairman and members of the subcommittee:
Good afternoon. My name is Daniel P. Dye and I am vice-president of Cargill North American Grain, based in Minneapolis. I also serve as chairman of the National Grain Trade Council on whose behalf I appear before you this afternoon. The Council is a national trade association whose voting members are grain exchanges and national grain marketing organizations. The Council's associate members are grain companies and related businesses. The Council's mix of membership provides it with a unique perspective on futures trading issues, such as reauthorization of the Commodity Futures Trading Commission.
As an overview of our testimony, the National Grain Trade Council supports efforts to modernize the Commodity Exchange Act to meet current and future demands of the United States' and global financial markets. The Council supports a number of reforms in the CEA, including streamlining regulation and comparable treatment for exchange-traded and off-exchange-traded products. In discussing over-the-counter products, we make several recommendations regarding the agricultural trade option pilot program and express concern with the evolution of crop insurance. We support aggressive efforts to provide risk management education for producers. Also in the nature of reforms to the CEA, we support updating the definition of a ''hedge'' and eliminating an antiquated delivery warehouse provision. Lastly, we urge Congress to guard against any effort to permit block trading in futures markets in making reforms to the CEA.
The Council supports reauthorization of the Commodity Futures Trading Commission, although in our testimony we will recommend changes in the CEA which will affect the role of the CFTC.
REFORMING THE CEA
The Council believes reform of the Commodity Exchange Act is overdue. The CEA was designed to address the challenges of an era that has come and gone. The CEA has spawned a regulatory structure that today is stifling innovation in a rapidly changing world. We believe a successful effort to reform the CEA should focus on how to rationalize regulation.
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Rationalizing regulation should include at least three elements: (1) Federal oversight; (2) minimal duplication of effort; (3) and efficient, but meaningful regulation.
Federal oversight: the role of the CFTC should be one of Federal oversight and more authority should be vested with exchanges as the front line regulator of the markets. As a starting point this framework would limit the role of the CFTC in areas like registration, reparations, and arbitration. As the role between the CFTC and exchanges shifts, exchanges will need to be ever more attuned to the needs of market users.
Minimizing Duplication of Effort: The Council believes it is time to change the regulatory structure so it does not foster and encourage duplication of effort between the private and public regulators. We would like to see more clarity between the responsibilities of the CFTC, National Futures Association, and the exchanges. The current system tends to promote duplication of effort in areas of audits and investigations and contract design, in particular. Market participants are frustrated with a system that results in identical investigations undertaken separately by the exchange and the CFTC. Audits and investigations are time consuming and costly for all. Separate, but identical actions only magnify those costs and create confusion. Ideally, the front line of audit and investigation authority should lie with the self-regulatory organizations and the CFTC would have strong authorities overseeing exchange enforcement performance. For self-regulation to work there must be confidence in each element of the system that would require a careful examination of the authorities and responsibilities of each of the regulatory entities.
Efficient, but Meaningful Regulation: The Council believes some steps can be taken to streamline the regulatory structure and yield efficient, but meaningful regulation. Rationalizing regulatory efforts, making them more efficient, should not lower customer safeguards. Exchanges should be allowed to list new contracts and implement new rules or rule changes without first seeking CFTC approval. The CEA should specify the guidelines for obtaining and maintaining a contract market designation. The Federal regulatory agency, in turn, should be given adequate disciplinary tools to give contract markets an incentive to maintain strict compliance with the charter for contract market designation. With those authorities in place, certain functions could be left to the self-regulatory organizations or the NFA. More clarity in the agency's role would help achieve this goal.
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Achieving these three goals to rationalizing regulation will not be easy. We have studied with interest the concept proposal put forward by the Chicago Board of Trade and Chicago Mercantile Exchange. Our initial reaction is favorable and we see it as a positive step forward in the debate. We compliment the exchanges for the fresh thinking that is evident in their proposal. There are many questions yet to be answered regarding the details of the Chicago proposal and we look forward to being part of that process.
OTC DERIVATIVES
In discussing reforms to the CEA, another key element to rationalizing regulation is gaining similar regulatory treatment for comparable instruments. Here again we believe the proposal from the Chicago exchanges offers some fresh thinking. Their proposal would place derivatives under the umbrella of the CEA, but would exempt instruments that are privately negotiated, leaving publicly traded instruments under the purview of the CEA.
This line of thinking can benefit the interests of the Chicago exchanges, the OTC community, and market users. If regulation is streamlined for exchanges there is more openness to providing legal certainty for OTC products. We believe that the marketplace will benefit from these types of reforms.
There is an agricultural issue affected by the OTC debate and that is what is an appropriate regulatory structure for agricultural trade options. We believe the regulatory structure approved by the Commission in 1998 for the agricultural trade options (ATO) pilot program should be streamlined. The Council recommends the following changes:
The exercise of the agricultural trade option should not require delivery. Even though it is likely that making physical delivery or allowing the option to expire will happen in the vast majority of options traded, there are some instances that will arise where both the buyer and seller would benefit by a negotiated or cash settlement to the option.
Even though we support the registration of agricultural trade option merchants with the Commission, we would like to see that registration process simplified.
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Producers should be allowed to write a covered call option.
We believe that once a trade option contract is purchased or sold, that the rules should allow that position to be offset prior to expiration. Such a change would provide users with important flexibility. In the normal course of a grain marketing year, agricultural businesses have a need to continually adjust and reassess market risk-reward profit potentials.
The requirement that ATOMs must file quarterly reports on agricultural trade option transactions should be dropped. In addition, we oppose the requirement that ATOMs must maintain internal controls similar to that required of a futures commission merchant.
CROP INSURANCE
The principal issue surrounding OTC derivatives is regulatory fairness—that Government should not create regulatory disparities that give one group a competitive advantage over another. We are very concerned as we watch the crop insurance program administered by the Federal Government evolve, and hear of ideas to expand the program further.
Multiple-peril crop insurance has traditionally been available to farmers to protect them against yield shortfalls. The Government has heavily subsidized that insurance coverage in an effort to keep premium costs for producers at affordable levels. More recently, revenue insurance has emerged, also subsidized, to protect farmers against price declines. Revenue insurance provides price protection very similar to what a producer might gain though options-based products already available in the marketplace. We are concerned that what is evolving is competition between a highly subsidized product and a non-subsidized product. That is not a rational situation and could be a very counter-productive in lessening producer interest in market-based solutions. We remain concerned about the potential market distorting effects of Federal subsidy programs and policies.
As Congress continues to discuss the adequacy of the Federal income safety net for farmers, one chief tool many Members have looked at is crop insurance. There have been a variety of proposals to provide dramatically increased Federal funding for crop insurance. This is an issue that merits close scrutiny before final decisions are reached. We are concerned that additional Federal support for crop insurance programs that include price risk management components may have significant unintended and negative consequences. The more Government seeks to manage price risk for producers by subsidizing crop insurance policies that contain price risk components, the more likely these products will distort both prices and planting decisions among producers. We are not so much opposed to Government support for traditional multiple-peril crop insurance as we are opposed to its expansion into revenue insurance products. There is a place for traditional crop insurance in a farmer's marketing plan, along with market-based marketing alternatives.
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We believe providing income support to producers should be separated from crop revenue insurance. There may be occasions when Congress should provide income assistance to farmers. We believe that assistance should be provided in a manner that is simple, direct, non-market distorting, and fair—fair to all crop producers, not just targeted toward certain regions.
RISK MANAGEMENT EDUCATION
The Council strongly supports aggressive efforts to provide farmers with risk management education; in particular with access to knowledge that will help them make informed marketing decisions. Private industry provides a variety of marketing alternatives to producers. There are products producers can use to lock in minimum and/or maximum prices, to protect against crop failures, to provide early-season financing, and many other innovative choices.
The Federal Government can play a constructive role in helping farmers become informed decision-makers when managing their price risk. There are good educational materials and programs Market education programs offered by the Illinois Farm Bureau, Kansas State University, National Cotton Council, and Texas A & M University are widely recognized for their excellence.
already in use in many areas. USDA can help by encouraging similar programs where there is a void. Additional funding in this area will be crucial to its success.
Let me also add a word of caution about market education programs. The goal should be clear—to help farmers become more knowledgeable of their marketing choices so they can make disciplined, profitable, and appropriate decisions. The right tool depends on circumstances and the producer's knowledge base.
National Grain Trade Council members—grain exchanges and grain companies—have years of experience in the business of price risk management. There are many products available today to help producers manage their price risk. Tomorrow there will be even more products, whether publicly traded or privately negotiated.
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HEDGE DEFINITION
Returning to recommendations for reforming the CEA, the Council supports including a provision to provide a more modern definition of a ''hedge'' in the CEA. The current definition focuses on ''price risk reduction'' and we would suggest the focus should be more on ''risk management''. If a farmer or grain company would wish to seek to hedge their business risk through an area yield futures contract, for example, that should be considered a hedge, even through it does not seek to reduce price risk.
One model to consider is the rewrite of Section 3 of the Commodity Exchange Act that was included in H.R. 467 in 1997. Included in that rewrite of '3 was language that began to address concerns about the lack of a hedge definition in the Act. One of the deficiencies of the current law is the lack of a working hedge definition for business purposes. Several years ago this deficiency nearly cost the business and farm community ordinary income tax treatment of hedges—a characterization critical to hedging strategies.
That situation created a period of uncertainty that lasted from 1988 to 1994 and really forced the industry to examine what kinds of hedging transactions would be treated as legitimate by the Internal Revenue Service. The issue, commonly referred to as Arkansas Best, involved the Internal Revenue Service's questionable interpretation of the Supreme Court case Arkansas Best Corporation v. Commissioner. In effect, the IRS challenged the legitimacy of modern hedging strategies and required that companies treat the gains and losses from many hedges as capital, rather than ordinary income. While in the end, most issues were successfully resolved through new regulations, several areas remain outside the scope of the IRS= action. In fact, commercial grain companies who considered using the Chicago Board of Trade's corn yield futures or options contracts still face Arkansas Best-related problems.
One of the problems lies in the existing '3 of the Act, where it describes the commercial use of futures and options as a means of hedging Aagainst possible loss through fluctuations in price.'' Hedging, as a commercial practice, is no longer limited to transactions that reduce price risk. Rather, hedging strategies are more appropriately described as risk managing activities. As proposed in H.R. 467, '3(a)(2) states that ACommodity futures and commodity options transaction are used to hedge and manage price or other economic risks faced by businesses and financial enterprises throughout the world.'' This is a step in the right direction.
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We would, however, encourage the subcommittee to go further and adopt a business definition of a hedge that will provide increased certainty for all commercial hedgers, whether they be hedging commodity or financial business risks.
The Council continues to believe that the Commodity Exchange Act is the appropriate place for the law to define the business activities classed as hedges. The lack of any meaningful definition in the law will continue to place hedgers at risk from other agencies, courts, or private standards groups—each defining for their own purposes what transactions constitute hedges and how they will be treated.
Delete Antiquated Delivery Warehouse Provision
Also in the nature of modernizing the Commodity Exchange Act is a request from the Kansas City Board of Trade to eliminate Section 5a(a)7 of the CEA. We believe this step is non-controversial.
Section 5a(a)7 of the CEA allows a federally-licensed warehouse to issue warehouse receipts in satisfaction of futures contracts made on or subject to the rules of an exchange, even if the warehouse is not approved by the exchange as registered for delivery. The KCBT points out that the provision is obsolete and hinders market surveillance efforts.
The provision is an original provision of the Act dating back to 1922 and has long since become obsolete. The effect of '5a(a)(7) is to allow any federally licensed warehouse to issue warehouse receipts in satisfaction of futures contracts made on or subject to the rules on an exchange, even if the warehouse is not approved by the exchange as a registered delivery warehouse. The provision presents a void in the self-regulatory structure, particularly with respect to the duties of the exchange to monitor markets for indications of congestion or market manipulation as demonstrated by the following:
Monitoring the availability of deliverable supplies of a commodity is difficult, if not impossible, under a situation where non-exchange member, federally licensed warehouses have the option of issuing warehouse receipts, but are under no obligation to report supply information to the exchange.
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The lack of accurate reporting of deliverable supplies raises the question about whether market participants can evaluate the market and make decisions about the feasibility of delivery on any given contract.
Most disconcerting is the notion that a federally licensed warehouse meeting minimal standards could manipulate a contract close by flooding a market with deliveries when it is economically beneficial to their position in the cash and/or futures market.
BLOCK TRADING
Lastly, as the subcommittee considers proposals to reform the Commodity Exchange Act, we urge you to guard against any move to permit block trading in futures markets. The Council believes that block trading is anti-competitive and contradicts the Commission's role, as specified by Congress under current law, ''to ensure that all trades are executed at competitive prices and . . . focused into the centralized marketplace to participate in the competitive determination of the price of futures contracts.'' 63 Fed. Reg. 3709 (1998) (quoting REPORT OF THE SENATE COMMITTEE ON AGRICLTURE AND FORESTRY, S. Rep. No. 1131, 93rd Cong., 2d Sess. 16 (1974)).
Block transactions discover and create futures prices outside the centralized marketplace. This discovery process clearly distinguishes block transactions from EFPs, office trades, or transfer trades. By comparison, the exchange of futures for physicals simultaneously fixes the components of a basis transaction in a cash commodity contract.
Block trading is also anti-competitive because it violates the purpose of an open and focused centralized marketplace to provide ''ready access to the market for all orders (which) results in a continuous flow of price information.'' 63 Fed. Reg. 3709.
We recognize that block trading is a practice common in securities markets. However, notwithstanding the recent development of hybrid securities-commodities products, at the basic level, securities and futures instruments and markets remain differentiated. Sanford J. Grossman, An Analysis of the Role of ''Insider Trading'' on Futures Markets, 59 J. BUS. S144-45 (1986).
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The instruments serve different functions—securities facilitate investment and represent equity ownership in a corporation, whereas commodity futures transfer price risk and enable price discovery. By establishing a separate regulatory structure for securities and futures markets, Congress has recognized that what is appropriate for one market may be inappropriate for the other.
The Council believes block trading is an unacceptable practice, which would concentrate trading into a few large institutional corporations. The outcome would drain liquidity, prevent equal access, curtail information, foster ''bucketing,'' Bucketing is defined as ''(d)irectly or indirectly taking the opposite side of a customer's order into the broker's own account or into an account in which the broker has an interest, without open and competitive execution of the order on an exchange.'' THE COMMODITY FUTURES TRADING COMMISSION, THE CFTC GLOSSARY: A LAYMAN'S GUIDE TO THE LANGUAGE OF THE FUTURES INDUSTRY (1990).
and, in short, destroy 150 years of public confidence in our markets. The greatest harm would befall the producer. We can think of no better example of harm wrought by allowing prearranged block trading than the damage to a farmer using the futures market to hedge five thousand bushels of grain production. To a large integrated company, a single contract to sell in the futures market, opposite the company's large buying order, may represent only one of thousands or tens of thousands of contracts purchased in a single transaction or during a trading day. However, to the farmer, that single contract represents an important percent of production, and the price received for it becomes an important element in his profit marketing for the year. The farmer is clearly harmed when the prospective counter party to his futures hedge can legally locate another large institution and contract with that party at a lower price.
In conclusion, Mr. Chairman, we compliment you and Mr. Condit for your efforts to modernize the Commodity Exchange Act to meet current and future demands of the United States' and global financial markets. We believe such a step is long overdue. We look forward to working with you on a solution that results in more rational regulation for exchanges, the OTC community, and market users.
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Statement of John G. Gaine
Mr. Chairman and members of the subcommittee, the Managed Funds Association appreciates the opportunity to testify here today. We commend your interest in assuring that the Commodity Exchange Act remains vital and constructive in today's marketplace. MFA is the nonprofit trade association for the managed futures and derivatives industry. MFA's more than 700 members provide diverse perspectives of alternative investment professionals, including hedge fund managers, commodity trading advisors, investment advisers, commodity pool operators and fund of funds managers. These professionals in the aggregate manage a significant amount of the nearly $300 billion invested in hedge funds and a vast majority of the over $35 billion invested in managed futures funds. MFA members trade in the over-the-counter markets, in domestic contract markets, on foreign markets and in the cash markets. They are endusers of all markets affected by the CEA and CFTC regulations.
Our members trade directly as customers for their own accounts and on behalf of their clients. In managing client accounts, a major component of compensation for MFA members is based on the performance of those accounts. MFA members therefore have interests that are directly aligned with those of the ultimate customer on virtually all CEA regulatory issues. Unnecessary regulatory costs of the exchanges (contract markets) and futures commission merchants (FCMs) are ultimately borne by the customer, and we are dedicated to seeing those costs eliminated. However, our membership also suffers costs if markets lack integrity or efficiency. Consequently, we support regulatory modernization and streamlining but believe that regulations essential to centralized market integrity must be preserved.
I will now turn briefly to MFA's views concerning several specific aspects of the current regulatory structure that we believe warrant consideration by the committee.
CEA Modernization. In general and for the reasons I have briefly stated, MFA strongly supports this committee's review of the CEA to determine whether legislative changes are appropriate to modernize the CEA to meet the challenges of our highly competitive global marketplace. In this connection, we congratulate the Chicago Mercantile Exchange and the Board of Trade of the City of Chicago on their development of a proposed conceptual framework (the Exchange Proposal) to reshape the CEA and CFTC regulation to respond to the competitive and regulatory challenges presented by today's markets and those of the next millennium. The Exchange Proposal sets forth general concepts and recommendations and leaves for further debate and refinement the specifics of many of the proposed new approaches. We consequently are not addressing the specifics of the regulatory design proposed. Nonetheless, MFA voices its support for the exchanges' general approach toward modernization of exchange regulation under the CEA.
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Today's highly competitive markets place a premium on the ability of exchanges and other market participants to respond efficiently and creatively to rapidly changing market developments here and abroad, including new technologies, new products, and new trading and clearing mechanisms. MFA supports efforts to fashion a revised regulatory and self-regulatory structure that would expand the ability of futures exchanges to meet these challenges by efficiently managing their day-to-day affairs and developing innovative new products and trading approaches. At the same time, key supervisory powers of the CFTC necessary to assure that self-regulatory functions are performed effectively and the integrity and fairness of the markets must be maintained.
Designing a new exchange regulatory model under which the CFTC's role is recast to provide for less routine review of new contracts and exchange rules, without compromising critical supervisory authority, is a difficult but valuable undertaking. This task requires that a careful balance be struck between the oversight role of the CFTC in preserving fair, efficient and orderly markets and the discretion of the exchanges to conduct business efficiently and competitively. Our futures markets are viewed worldwide as a model of competitive markets and those features of our regulatory structure essential to market integrity must be retained. Further, MFA believes that it is of utmost importance to the global competitiveness of the U.S. financial services sector to have a strong, independent agency focused on fostering market integrity and efficient, liquid markets, at the lowest cost and the least possible interference with market and product innovation.
MFA agrees with the evident intent of the Exchange Proposal that matters such as CFTC review of new contracts and exchange rules can be significantly limited. In defining the optimal balance between CFTC oversight powers and exchange discretion, MFA continues to believe one sound approach is to tailor regulatory requirements to the qualifications of the participants in the marketplace. This is an approach which the CFTC has successfully employed in a number of contexts, including the Rule 4.7 exemption for the offering of commodity pools to highly accredited investors. MFA believes that elimination of burdensome and costly regulation unnecessary for the protection of professional participants in the market benefits the marketplace, without detriment to the integrity of the market. MFA thus continues to advocate a two-tiered regulatory approach as a sound, proven approach to responsible regulatory streamlining.
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Hedge Fund and Commodity Pool Issues. The President's Working Group on Financial Markets recently issued a study, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, which addresses a number of topics of direct interest to MFA's members. MFA also has just produced a paper on the same matters: Hedge Funds: Issues for Public Policy Makers. MFA testified before the House Banking Committee concerning the Working Group Report and will submit that testimony as well as MFA's policy paper for the record here. I will simply highlight MFA's views on several key points. First, we agree with the Working Group that the most effective protection against events such as those involving LTCM is sound market discipline. Augmenting and reinforcing market discipline therefore should be the central concern of public policy makers. Second, we agree with the Working Group that no additional direct regulation of hedge funds is warranted. Third, MFA takes issue with the Working Group's recommendation for additional reporting by hedge funds to regulators and the public. We do not believe that the reporting envisioned by the Working Group addresses the issues raised by LTCM or serves the public interest. The Working Group's recommendation calls for quarterly reporting of a snapshot of stale data which would, not in our view, provide any antidote to LTCM-type events and or provide meaningful insights to regulators or the investing public concerning the operations of the reporting fund. We thus seriously question the utility of such a requirement and note that a new requirement such as this is precisely the type of administrative burden and selective public dissemination of fund data which gives incentives to funds to avoid operating in the U.S. We note that Chairperson Born has testified that CFTC staff are already preparing rules to implement the Working Group's recommendation on this point. We urge this committee to exercise its oversight authority to assure that no precipitous action is taken that will damage the competitiveness of the U.S. managed funds marketplace.
Legal Certainty. MFA supports efforts to give greater legal certainty to over-the-counter (OTC) derivative products such as swaps, hybrid products and foreign currency transactions. The development of OTC derivative markets has been a significant factor in the growth of the world economy. These markets provide invaluable economic benefits throughout the world of finance and industry. These markets, characterized by self-regulation and discipline, consist of sophisticated counterparties and have operated free of any significant regulatory problems. The growth and vitality of these important markets demand a strong legal foundation so that transactions can be conducted without parties assuming a high degree of legal risk, as has been extensively addressed by other witnesses before this committee. MFA supports appropriate CEA amendments to foster legal certainty. Furthermore, MFA does not believe the CFTC has fully utilized the exemptive authority that Congress granted it in 1992. MFA believes there are additional over-the-counter markets that should be granted exemptive relief.
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MFA also wishes to bring to the committee's attention a subject which, while not directly under review by this committee, significantly impacts the competitiveness of the U.S. futures markets and their users.
Elimination of Duplicative Regulatory Oversight of Publicly Offered Commodity Pools. Public commodity pools are a significant and increasingly important part of the U.S. financial services industry. However, as most commodity pools are organized as limited partnerships, the offer and sale of their interests is subject not only to CFTC regulation but also to the Federal and state securities laws. Duplicative oversight by the Securities and Exchange Commission (SEC) of commodity pools subject to CFTC regulation presents particular problems of delay and expense for publicly offered commodity pools, the prospectuses for which are subject not only to an extensive and detailed review by the CFTC but also often protracted review by the SEC, not to mention the 50 state securities regulators, before interests in the pool may be offered to investors. Although this is not a matter directly within the jurisdiction of this committee, MFA believes that the committee's objective of modernizing the regulatory structure to respond to today's competitive environment warrants attention to this long-overlooked problem of regulatory overload.
By way of background, I note that the CFTC was granted exclusive jurisdiction over futures and commodity options in 1974 precisely to prevent this type of regulatory layering, with its potential for inconsistent treatment and bureaucratic stalemates. In 1982, the CEA was amended to clarify that despite the CFTC's exclusive jurisdiction over futures activities, to the extent that commodity pools are offered in securities offerings, the SEC and private parties have rights and remedies arising under the Federal securities laws with respect to transactions in such securities and reporting by the issuer of such securities. While thus permitting, for example, the SEC and private parties to seek redress for fraudulent conduct in connection with securities offerings, this statutory amendment was not, we believe, designed to legitimize duplicative regulatory oversight by the CFTC and the SEC. Nonetheless, as a matter of historical practice, the CFTC has reviewed the disclosure documents for all commodity pools.In October 1997, the CFTC delegated responsibility for the review of disclosure documents for privately offered commodity pools to the National Futures Association.
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and the SEC has reviewed disclosure documents for publicly offered commodity pools. This overlap is significant, unnecessary and costly to the commodity pool industry and the investing public. The organizational costs of a large public pool offering are substantial; and a significant portion of these costs are attributable to the review process at the SEC and multiple state securities regulators. These costs and delays are excessive and unnecessary given the comprehensive review of the identical documents by the CFTC. We do not believe that Congress intended that commodity pools subject to CFTC jurisdiction be subjected to this type of regulatory duplication. MFA urges the committee to support the elimination of duplicative regulatory oversight of publicly offered commodity pools.
Conclusion. In conclusion, let me again express MFA's support for this committee's interest in modernizing the Commodity Exchange Act. MFA would be pleased to assist the committee in any way that it may find helpful during the conduct of its reauthorization hearings. Thank you for your attention and the opportunity to present the views of the Managed Funds Association. I would be happy to respond to any questions you may have.
Testimony of Kendell Keith
Chairman Ewing, Congressman Condit, and members of the subcommittee. My name is Kendell W. Keith. I am president of the National Grain and Feed Association.
The National Grain and Feed Association (NGFA) is the U.S.-based nonprofit trade association of 1,000 grain, feed and processing firms comprising 5,000 facilities that handle more than two-thirds of all U.S. grain and oilseeds. Our membership encompasses all sectors of the industry, including country elevators, terminal elevators, exporters, feed mills, cash grain and feed merchants, livestock integrators, grain and oilseed processors, and futures commission merchants.
GOALS OF GOVERNMENT OVERSIGHT OF MARKETS AND RISK MANAGEMENT ACTIVITIES
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We recognize the primary focus of these hearings is the reauthorization of the Commodity Futures Trading Commission. We would, however, urge Congress to use this legislative review as an opportunity to more thoroughly evaluate Government's role in oversight of markets and risk management activities. Technological developments; the deregulation of U.S. agriculture through the FAIR Act of 1996; international competition in risk management; and the potential expansion of crop insurance programs are some of the major factors that are shaping policy issues on risk management. The confluence of these major trends indicates a need for a substantial re-shaping of Government's role.
We would urge Congress to consider the following goals in the re-shaping of policy:
(1) Continued strong Government protection against market manipulation and fraud;
(2) Preserving liquidity and transparency in regulated futures exchanges;
(3) Ensuring a level playing field among competitors and potential competitors; and
(4) Less reliance on direct Government oversight in favor of more reliance on self-regulatory organizations and competitive market forces to police market behavior.
CFTC SHOULD BE RE-AUTHORIZED; LEGAL DUTIES MORE NARROWLY DEFINED
The National Grain and Feed Association supports the reauthorization of the Commodity Futures Trading Commission for a period of 4 to 5 years. Futures markets, whether in physical commodities or in financials and other products, are substantially different than securities and stocks and need an independent regulator that understands the characteristics and unique regulatory issues of relevance to such markets. CFTC serves that role as independent regulator.
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While supporting the continuation of the CFTC as an independent agency, we would urge Congress to more clearly define the regulatory authority of the agency and to narrow its regulatory functions. The Commodity Exchange Act historically has given the CFTC considerable discretion in determining jurisdictional boundaries. Experiences in the last few years suggest to us that a narrowing of these legal boundaries could function to better serve the intended purpose of the law, the interests of the general public, commercial businesses and the entire marketplace.
The Chicago Board of Trade and Chicago Mercantile Exchange have jointly advanced the concept that the CFTC should become more of a supervisory and oversight agency, leaving the prescription of contract terms, trading rules, and other matters to exchanges or other self-regulatory institutions. While specific legislative language of this proposal has not been released, we are in general agreement with the concept.
We have seen evidence of the CFTC struggling at times to define its appropriate regulatory role within its currently broad statutory authorities. In one situation, in September 1997, the CFTC issued a proposed order to re-write contract delivery terms for certain CBOT contracts. We objected to that regulatory process, and informed the CFTC, ''The division of authority and responsibility between the CFTC and the self-regulatory authorities, i.e. the CBOT (in this case) should be clear.'' CFTC should have the right to approve or disapprove proposed terms deemed not to meet statutory tests of the Commodity Exchange Act, but not to unilaterally design contract terms. In short, we support legislative language that more clearly stipulates this role to the CFTC so as there is no confusion. Exchanges are regulated private enterprises that need reasonable discretion to make judgements on the appropriate design of commercial contracts. To the extent such private enterprises fail to serve the needs of their customer base, competition should be permitted to police market behavior. (See section below on competitive markets.)
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There are several reasons for more narrowly defining CFTC legal authorities:
(1) There are competent self-regulatory organizations in place and the CFTC should make use of them and allow them the discretion to do their job;
(2) Rapid changes in international and electronic markets appear to be taxing the resources of the agency and scarce CFTC resources could be invested more wisely in monitoring such developments and how they affect the competitive structure of markets;
(3) CFTC should invest more of its resources in assessing how competition can be encouraged and nurtured so as to become more effective in regulating behavior, thus reducing the need for extensive Federal oversight.
COMPETITIVE MARKETS ARE THE BEST REGULATOR
The principal reasons for having a Federal regulator of certain markets remains the same today as it was in the 1930's—-to prevent attempts at market manipulation and to prosecute cases of fraud. This regulatory function of the CFTC must remain solidly in place. However, the regulatory process has gone far beyond these basic principles and has led to a cumbersome, legalistic, technical set of rules and guidelines that no longer serve well the needs of market participants they were designed to protect.
A futures exchange, being run as a private, for-profit enterprise, should have a right to determine what forms of contracts and options markets are most desired by hedgers and speculators and make business strategy choices to serve potential customers. If the existing markets fail to serve the needs of customers—-if market participation wanes because of poor contract design, trading rules of the exchange or other reasons—-competitive exchanges should be free to offer competitive market contracts under similar circumstances. In this day of expanding electronic commerce and expanding international competitors, competition can be fierce and a great motivator to exchanges to serve the needs of the customer base. The CFTC can facilitate the market's ability to self-police behavior by:
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(1) Ensuring that there are not inordinate barriers to entry for potential new exchanges; (2) Treating existing exchanges with equivalency, i.e., the competitive circumstances and regulatory review, if any, prior to contract introduction should be the same for existing and any new exchanges; and (3) Ensuring that CFTC-regulated products are not dis-advantaged in competing against near-economic equivalent products in OTC or derivative markets.
CASH MARKETS NEED A REGULATORY BRIGHT LINE STANDARD
Cash forward contracts, in which delivery is to occur in the future, have been excluded by statute from regulation by the CFTC and its predecessor agencies since 1921. The so-called forward contract exclusion has been contained in all acts since that time with the language virtually unchanged.
As recently as the early 1980's, this forward contract exclusion remained adequate as a bright line standard separating those contracts clearly exempt from CFTC oversight from those under CFTC jurisdiction.
More modern contract developments, in particular with the advent of exchange-traded options, led the CFTC to issue its 1985 Interpretive Statement to clarify the regulatory treatment of certain classes of cash contracts. This statement was helpful and served the market, but today, it too is inadequate. Through informal dialogue with the CFTC and its staff, we perceive considerable confusion about the purpose and commercial utility of many existing cash contracting tools. Such confusion is, in our view, a risk to the commercial market. Highly useful commercial contracts may be at risk of being declared invalid or illegal by the CFTC on some technical legal distinction that in fact has no bearing on the fundamental economic terms or usage of the contract.
In short, cash grain companies confront considerable legal uncertainty in cash contract markets and seek clarity in the jurisdiction of the CFTC as a means of clarifying legal parameters and managing litigation risk exposure. We would offer the following legislative language amendments for consideration by Congress, the CFTC and other groups that might have interest:
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Proposed amendment to Section 1a(11) would read as follows (new material underlined):
(11) Future delivery. - The term future delivery does not include any sale of any cash commodity pursuant to a privately negotiated contract for deferred shipment or delivery between persons who have the capacity, directly or indirectly, to make or take delivery through any bona fide means of conveying legal ownership.
This proposed language would appear consistent with the suggestion by the CBOT and the CME to treat privately negotiated (as opposed to publicly traded) contracts as excluded from jurisdiction under the Act.
While subject to additional clarification, we would envision examples of bona fide means of conveying legal ownership to include delivery of the physical commodity, bills of lading stipulating the seller as holder of title, or warehouse receipts.
NGFA proposes this statute clarification with the belief that it reflects existing case law and CFTC interpretative statements relied upon by all industry participants before 1996.
Recognizing that this statutory language has a long history, we would welcome the comments and dialogue of other interested parties as Congress considers the best approach to greater legal certainty.
COMPETITION AND THE NEED TO AVOID PRIVILEGED GROUPS IN RISK MANAGEMENT
Competition is healthy for a marketplace. Through strong competition, those that offer risk management products to farmers and others will be driven to offer better service, more competitive pricing and more rapid improvement in risk management features.
To enhance competition and its beneficial impact on markets, CFTC should guard against regulations that create barriers to entry for new markets or new contracts, or that may create an uneven playing field for competitive businesses.
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Similarly, we would urge Congress to not create privileged groups among businesses competing in the offering of risk management services.
As an example, crop insurance is a needed component of the risk management tools available to the grain farmer. Given the history of ad hoc disaster programs, and the general disincentives for the purchase of crop insurance caused by such, it is probably necessary that crop insurance be subsidized to encourage a reasonable participation by farmers.
However, Congress faces a risk of excessive subsidization of crop insurance, in particular products that contain a price-protection component. USDA research has demonstrated that crop insurance revenue protection above the 75 percent level may create disincentives for farmers using other price protection tools, such as exchange-traded futures and options or cash contracts. Such heavy subsidization not only creates a competitive imbalance in the market, but also discourages farmers from early cash marketing of grains and oilseeds. Neither outcome is desirable. Thus, excessive subsidization can work against the creation of competitive alternatives and the benefits of a competitive market, such as lower prices and enhanced product development.
There are other imbalances that should be rectified. For cash grain companies interested in offering revenue-protection contracts to farmers, such companies face not only the subsidized competition from USDA-approved revenue insurance, but also a substantial legal barrier. Unless CFTC substantially amends its existing agricultural trade option program rules, a cash-settled revenue protection contract is probably illegal.
Clearly, there is substantial room for enhancing the competition among providers of risk management services and tools to farmers.
AGRICULTURAL TRADE OPTIONS NEED A JUMP START FROM CONGRESS
More than 2 years ago, our Association testified before this subcommittee about the need to develop more comprehensive tools for risk management. Following the passage of the FAIR Act, farmers clearly need both encouragement and the tools to meet the challenges of risk management in a less regulated environment. In our view the progress toward offering farmers an expanded menu of risk management tools has been woefully inadequate.
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Agricultural trade options (ATOs) offer a potentially valuable tool for both farmers and commercial interests, but unfortunately, have not proven to be practical under the CFTC's pilot program. As you are probably aware, no firm has signed up under the program. The reason is simple. Through heavy and unnecessary layers of regulation, the CFTC has raised the cost of becoming a merchant of ag trade options to such a high level that no one perceives compensating benefits to be adequate to make the heavy investment. Another significant problem with the program is that while the CFTC's program offers very limited new flexibility in cash contracting through its ATO pilot program, it also prohibits one of the most important contractual rights that farmers have in every other cash contract in use today. That is, the CFTC ATO pilot program prohibits the buyer and seller of the ag trade option from reaching a mutually acceptable cash settlement prior to expiration. This prohibits the farmer from benefiting from any arbitrage opportunities. It prohibits the farmer from extracting remaining time value of the option in the event of crop failure. In short, the prohibition of cash settlement eliminated much of the potential value in ATOs.
The National Grain and Feed Association, along with a number of other farm groups and merchandising organizations, have had recent dialogue with the CFTC concerning the need to substantially revise the ATO pilot program rules to obtain any degree of participation in that program. While we are encouraged by the apparent commitment of the agency, we remain concerned whether the CFTC, acting on its own, will make the extensive necessary adjustments for a successful ATO program without the affirmative support from Congress.
In that regard, we would propose that Congress consider legislation specifying the parameters of a viable ag trade option program, or providing specific direction and legislative support to the CFTC to administratively implement such rules without further delay. We would also recommend that the legislation stipulate that, following a successful ATO program, the CFTC be required to eliminate existing regulations that treat agricultural trade options differently than other trade options on non-enumerated commodities. ATOs are cash contracts and should be treated as such. The CFTC should not be permitted to establish itself as a permanent overseer of cash commodity markets, a prospect neither desirable nor ever intended by the Act.
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We appreciate the opportunity to participate in these hearings.
Testimony of Daniel J. Roth
My name is Daniel Roth, and I am vice-president and general counsel of National Futures Association. NFA appreciates the opportunity to appear here today to present our views on some of the issues facing Congress as it begins the reauthorization process. Ultimately, it's up to Congress to ensure that the regulatory structure for the futures industry keeps pace with the changes in the industry itself. Given the profound changes sweeping the industry, the challenge facing Congress is huge.
Change and innovation have always been the lifeblood of the futures industry, but the most dramatic change over the last couple of years has been the pace of change itself. The futures industry is going though a period of constant and rapid innovation. The continuing revolution of technology has changed every facet of the industry—who trades on these markets, where they trade and how they trade. In fact, about the only thing that hasn't changed in recent years is the basic regulatory structure that Congress created in the Commodity Exchange Act.
When the regulatory structure lags so far behind the industry, all of us are in a precarious position. Exchanges and futures commission merchants may differ strongly on certain points, but they all have one thing in common. They all face intense competition every day. The race belongs to those who can deliver the best products at the lowest price, and inefficiencies of any kind simply cannot be tolerated. That goes for inefficient regulation too. Rules which are unnecessarily burdensome were once a costly nuisance. Now they are potentially fatal to any business in this industry. All of these factors frame the basic question confronting Congress in this reauthorization process: How can Congress reduce the regulatory burdens imposed on every sector of the futures industry without reducing core regulatory protections?
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Before I go over our thoughts on that question, let me remind you that our perspective is a little bit different than the other witnesses you will have heard from. Like the exchanges, we are a self-regulatory body, but, unlike the exchanges, we operate no marketplace and do not face the competitive issues which confront exchanges. Like the trade associations, we are a membership organization, but we are not a lobbying organization. We are first, foremost and finally a regulatory body. Our 4,000 members include futures commission merchants (FCMs), introducing brokers (IBs), commodity pool operators (CPOs) and commodity trading advisors (CTAs). We regulate not only our Members' dealings with the public but also the activities of the 50,000 registered account executives who work for those Members. We do that job with a staff of approximately 280 people and a budget of $30 million, all of which is paid by the futures industry.
Which brings us back to the basic question facing Congress—How to reduce regulatory burdens without reducing regulatory protections. That's really the thrust of the five-point program outlined by the exchanges, a program which NFA supports. To NFA, though, a central point in the exchange proposal is the greater use of self-regulation to achieve regulatory efficiency. Self-regulation is a known and proven commodity—you know it works because you have seen it work. Let me give just one example.
Each CPO and CTA is required to give each prospective customer a prospectus type document called a disclosure document. Until October 1997, CPOs and CTAs had to file their disclosure documents with both the CFTC and NFA. NFA had to review the documents because we perform the audits of CPOs and CTAs. The CFTC reviewed the document to ensure it was in compliance with CFTC rules. It never made a lick of sense to us to have both organizations reviewing the same documents for the same basic points.
The Commission finally agreed with us and delegated to NFA the responsibility to review the vast majority of disclosure documents. It is now about a year-and-a-half later, and if you check with CPOs and CTAs, you will hear that they are very pleased that we listened to their complaints about the CFTC review process and did something about it. Our turnaround time averages five days. If there's no problem with the document, the Member hears about it right away. If there is an issue, the Member receives guidance that is personal, prompt and accurate. If you check with the CFTC, they will tell you that they have reviewed every aspect of our program and are completely satisfied with the job NFA is doing. In the meantime, valuable Commission resources have been freed up which the Commission can apply where they are most needed. In the grand scheme of things, the review of CPO and CTA disclosure documents by NFA may seem like a minor point, but I think the example is an illuminating one. Everyone wins when we make the best use of self-regulation.
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With respect to CPO disclosure documents, there are still inefficiencies built into the system which Congress should eliminate. CPOs which offer public pools are subject to regulation not only by the CFTC and NFA but also by the SEC. The SEC, for example, reviews the same disclosure documents which are already subject to review by the CFTC and NFA. There just has to be a better way to spend SEC resources than by duplicating the efforts of the CFTC and NFA. Regulation of these public pools by the SEC is a redundancy which Congress should cure by giving the CFTC exclusive jurisdiction over those pools.
I should also point out that reviewing disclosure documents is just the latest example of a long list of additional responsibilities NFA has assumed over the years. The Commission has delegated to NFA responsibility for processing registration applications for all categories of registrant; for revoking and denying registrations where appropriate; for tracking compliance with ethics training requirements and approving ethics training providers; and for processing applications for exemptions from registration for foreign firms.
Though the concept of self-regulation is a proven success, the current regulatory structure not only doesn't take full advantage of self-regulation but actually undercuts its effectiveness. Self-regulation works best when the Commission plays a true oversight role and doesn't attempt to micro-manage the self-regulatory process. The Commission performs periodic rule enforcement reviews of every part of our operation—from arbitration to registration to compliance and everything in between—to see if we are meeting our statutory obligations. In fact, NFA pays far more in CFTC oversight fees than any exchange and we don't object because we feel that this sort of periodic monitoring is consistent with the Commission's oversight role.
Oversight becomes micro-management, though, when every rule change we propose is subject to an elaborate and prolonged examination by the CFTC. The rule approval process can drag on literally for years as the Commission examines every comma in excruciating detail. The Commission ceases to act as an oversight agency when it, instead, acts as our Board of Directors. It's even worse for the exchanges because this sort of approval process applies to new products as well as to new rules. Like any other marketplace, success is often determined by who is the first to develop and implement a bright new idea. For the exchanges, though, building a better mouse trap is only the start of the process. Obtaining approval for that mouse trap is the real key and real disadvantage in dealing with over-the-counter and foreign competitors who do not have to clear that hurdle. When you consider the mortality rate of new contracts, it's clear that the marketplace is ruthlessly effective in its own contract approval process. The bottom line for us is that the Act should not require Commission approval of each new contract offered by an exchange and each new rule developed by any self-regulatory organization (SRO). The question the Commission should address is not whether it happens to agree with each rule the SRO adopts but whether the SRO is fulfilling its statutory mandate.
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The Commission also strays from its appropriate role as an oversight agency when it performs front line regulatory responsibilities that are already carried out by an SRO. The Commission's reparations program is a perfect example. When it was originally established, there was no NFA, boiler rooms were rampant, and there was no real alternative to litigation for the legions of small customers victimized by those boiler rooms.
The world is a much different place now. Together, the CFTC and NFA have cracked down on sales practice fraud and, while there are still problems to be addressed, the large scale boiler rooms are, thankfully, a thing of the past. In addition, NFA's arbitration program has grown and matured. NFA's program offers a more informal alternative to reparations. NFA has arbitrators all across the country and hearings can generally be held in the customer's backyard. Our average turnaround time is just seven months and, according to the General Accounting Office, our recovery rates are almost identical to the reparations program's.
The impact of all of these changes on the reparations program has been dramatic. In 1982, before NFA began operations, there were 1,079 cases filed with the Commission. Last year there were 215, almost the same number that were filed with NFA. Simply stated, the reparations program has outlived its usefulness and we see no reason why the CFTC should be the only Federal regulatory agency that maintains a dispute resolution forum. Just like the delegation of the disclosure document review function, elimination of the reparations program would allow the Commission to reallocate valuable resources where they are most needed. For example, the Commission is the only cop on the beat for all of the fraud committed by unregistered firms and individuals. I am sure the Commission would love to find a way to put more of its energy into that area.
When you consider the general topic of sales practice fraud by unregistered firms, you have to confront the Treasury Amendment. For the most part the Treasury Amendment has done just what Congress intended—it has allowed a marketplace of sophisticated, institutional participants to grow and develop unencumbered by regulatory protections intended for less sophisticated customers. But Congress could not have intended in 1974, and cannot intend today, to deprive retail customers of the important regulatory protections provided by the Act simply because a boiler room happens to be selling currency products. From a regulator's viewpoint, it's very frustrating to see individuals and firms that we expel from NFA for fraud, open up a new boiler room under the protection of the Treasury Amendment where they are beyond the reach of either NFA or the CFTC. Whether Congress ultimately adopts the exchanges proposal or some other approach, the result has got to be the same-retail sales of Treasury Amendment products by otherwise unregulated entities should be covered by the Act.
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Customer protection is the heart of what we do at NFA and I would like to clear up one possible misconception that is relevant to the repeal of the Shad-Johnson accord. Some have voiced concern that the futures industry's sales practice rules don't provide the same protection that suitability rules in the securities industry provide. The fact is that NFA adopted a Know Your Customer Rule in 1985 and has vigorously enforced it ever since. The only real difference between the rules is based on basic differences between the futures and securities industries.
In the securities industry, account executives have a range of financial products to recommend to their customers, all with varying degrees of risk and all serving different investment objectives. Therefore, the suitability rules require account executives to obtain basic information about their customers and to recommend only those transactions that are appropriate in light of the customer's experience, needs and financial situation. By contrast, futures and options contracts all involve a high degree of risk and volatility, and there is little or no basis for assuming that a trade in soy bean futures contracts would be appropriate for a particular customer but that a heating oil contract would not. The more appropriate focus in the futures industry is whether the customer should be trading futures at all. Therefore, NFA's rule requires that the Member firm obtain the same type of information about the customer that suitability rules require. If the customer has no business trading in these markets, the firm has to tell him exactly that. In short, the differences between suitability rules and our Know Your Customer Rule are not significant and the basic type of protection afforded by each is the same.
The final point I would like to make returns to the basic question of how to reduce regulatory burdens without reducing regulatory protections. The issue has come up most recently in connection with the placement of foreign terminals here in the U.S. NFA supports the Commission's recent move to expedite relief for foreign exchanges and to withdraw the complex rules the Commission had proposed. An equally important part of the Commission's initiative, though, is to review the regulatory burdens imposed on electronic trading by U.S. exchanges to address any competitive disadvantages current regulations may create. The Commission has created a subcommittee of the Global Markets Advisory Committee to undertake this task. The subcommittee, which is chaired by Leo Melamed, includes representatives from NFA, U.S. exchanges, money managers and FCMs. We are very hopeful that the subcommittee will come up with recommendations that have a broad base of industry support within the next few weeks. If any of those recommendations require legislative action, I am sure those issues will be brought to your attention.
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In closing, let me state again that NFA is proud of the efficiency we have brought to the regulatory process, we are confident that expanded use of self-regulation will help ensure that regulation keeps pace with changes in the industry, and we stand willing to help in that effort in any way the Commission or Congress deems appropriate.
Statement of American Cotton Shippers Association
The American Cotton Shippers Association (ACSA), an original supporter of the Commodity Futures Trading Commission (CFTC) as an independent regulatory agency, urges the Congress to reauthorize the CFTC for an additional term of 5 years and to maintain its authority to regulate ''all forms of futures and options trading.''
ACSA's support for the CFTC was, and continues to be, premised on the imperative to provide a diversity of regulated contract markets which enhance the workings of the physical marketing systems of the various commodities by providing price discovery and allowing for the prudent management of risks for producers, merchants, and processors. The myriad of changes in the commodity markets, the increasing use of these markets as a hedging tool by the business sector, and the significant expansion in liquidity has resulted in the development of an ever increasing number of diversified contracts which now requires the Congress to consider providing the exchanges with more self regulatory authority in the development and trading of new contracts and in the refinement of existing contracts.
Interest of ACSA. ACSA was founded 75 years ago, in 1924, and is composed of primary buyers, mill service agents, merchants, shippers, and exporters of raw cotton who are members of four federated associations located in 16 States throughout the Cotton Belt:
Atlantic Cotton Association (AL, FL, GA, NC, SC, & VA); Southern Cotton Association (AR, LA, MS, MO, & TN); Texas Cotton Association (OK & TX); Western Cotton Shippers Association (AZ, CA, & NM)
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ACSA's member firms handle over 80 percent of the US cotton sold in domestic and export markets. Because of their involvement in the purchase, sale, and hedging of cotton, ACSA members are directly effected by any action of the Congress involving the regulation of the various contract markets. The futures and options markets are a necessary and vital adjunct to our business operations. Our interest is manifest in the various proposals before the subcommittee since the sound and effective functioning of the futures and options markets is in the best interests of our members and our producer and textile mill customers.
Background. In 1974, ACSA was among a handful of advocates who urged the Congress to remove the regulation of the trading of agricultural commodities from the Department of Agriculture through the establishment of an independent regulatory agency with authority to regulate all commodity contract markets. In October 1973, the House Agriculture Committee began consideration of reforming the regulation of commodity futures trading following the completion of extensive hearings conducted by the Small Business Subcommittee chaired by Representative Neal Smith (D-IO). The USDA, speaking through the CEA Administrator, Alex Caldwell, recommended to the Committee that all futures trading be subject to federal regulation. In November, Committee Chairman, W.R. Poage (D-TX), appointed a Special Subcommittee to consider changes in the Commodity Exchange Act. In short order, the Special Subcommittee recommended that the CEA be replaced by a 5 person Commission, the CFTC, consisting of the Secretary of Agriculture and 4 public members required to be knowledgeable in the intricacies of futures transactions. Considered, and rejected, were proposals to create what Congress ultimately established, an independent regulatory agency; combining the CEA functions with the SEC; and the status quo of continuing the CEA in USDA. Included in the recommendations were the regulation of all exchange traded contracts and the requirement that all contract markets submit contracts for prior approval along with the Bylaws pertaining to trading in the contract market.
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In February 1974, the House Agriculture Committee reported its CEA reform legislation, H.R. 13113, and on April 11th, the legislation passed the House by a record vote of 281 to 43 after rejecting, by a vote of 158 to 179, an amendment to replace the 4 public members with 4 full-time government employees. In May, the General Accounting Office issued a report recommending that commodity regulation be removed from USDA since it lacked the resources to adequately police the markets. The GAO also focused on the Department*s inherent conflicting interests given its Congressional mandate to *influence and maintain* commodity prices. The GAO opined that *to remove any appearance of a conflict of interest and to instill full public confidence, the Congress should establish an independent agency, separate from the Department of Agriculture, to regulate all trading in commodities futures.* Further, the GAO noted that the futures markets were *vital to the country*s economic well-being* and should be regulated by a *strong, independent agency.*
In May, the Senate Agriculture Committee conducted hearings, and in August, a Bill was reported establishing an independent regulatory commissions, the CFTC, with 5 full time commissioners. On September 9th, following a half hour of debate with only 3 Senators present and voting, H.R. 13113 was enacted, establishing regulatory authority over all exchange traded commodities. On October 23rd, President Gerald Ford signed the Commodity Futures Trading Commission Act of 1974.
Until that time, the regulatory authority over commodity futures trading was vested in an agency within the U.S. Department of Agriculture, the Commodity Exchange Administration (CEA), and limited to the contract markets trading agricultural commodities. The unregulated commodities, gold, silver and other precious metals, were
self regulated by the contract markets on which they were traded. In 1973 October 9, 1973, Agricultural Economics Conference, Kansas City, Kansas.
, Senator Robert J. Dole recommended that the regulatory jurisdiction of the CEA be extended to include trading in all contracts for future delivery, noting that the public desired and required this protection. Further, he observed that should a problem occur in a non-regulated futures market that it would reflect badly on all other futures markets.
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America had just ended a regretful period of Government price controls, inflationary pressures were unleashed on the market place, and commodity prices were rising to new plateaus driven by significant increases in the price of oil and other energy products vital to maintaining our productive resources. Further, no financial or stock options contracts existed, and it was around this time that the world's financial powers, who were signatories to the Bretton-Woods Agreement, abandoned the concept of fixed currency rates in effect since 1945 and agreed to let market forces determine the value of the various world currencies. This action soon led to the development of contract markets for the trading of the various currencies. By the early 1980's, trading in stock index futures began and soon thereafter the ban on the trade of agricultural options was lifted by the Congress. The success of these markets is well documented and trading volume has soared in geometric proportions.
More importantly, the regulation of the these markets has been highly effective, accomplished with minimal resources, and only in the past 2 years has the Commission attempted to overly intrude in the markets. In the 25 years of its existence, CFTC has provided the trading public the necessary confidence to utilize the markets and has materially assisted in the phenomenal expansion of the US futures industry.
CONGRESS SHOULD CONSIDER DEREGULATING CONTRACT MARKETS
The CFTC was established because the Congress and the American public deemed the regulatory scheme in effect in 1974 to be too limited and ineffective. Over the years the contract markets have demonstrated their ability to effectively change with the times by providing new risk management contracts utilizing the latest technology for clearing trades while making available price discovery to the market participants backed by the integrity of the exchanges. Therefore, we support further deregulation of the contract markets. Because we believe it is of paramount importance that the public retain its confidence in the markets, we suggest that the Congress take an incremental approach. It is imperative that the deregulated markets provide the trading public the full opportunity to participate in the development of new contracts, particularly in the formulation of contract terms and trading rules. Given the assurance of an adequate and meaningful voice in the contract markets the public interest will be served, thereby obviating the need for a CFTC role.
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Since the inception of the CFTC's regulatory role, the public has developed a high degree of trust and confidence in the trading practices of the established contracts. The members of the agriculture community are particularly concerned that the integrity of the markets be maintained as the FAIR Act phases down the Government's role in providing a safety net to farmers and requires them to turn to the futures and options markets to manage their risks. Fair and effective regulation is the primary reason for farmers to have trust and confidence in the futures markets, therefore, the deregulatory process must not deter producers from making use of these essential risk management tools. Without the trust and confidence of the trading public the commercial users of the contract markets will be deprived of the ability to hedge and prudently manage the risks inherent in their businesses.
Testimony of George E. Crapple
Mr. Chairman, thank you for the opportunity to testify. I appear as chairman of the Managed Funds Association, a national trade association representing more than 700 participants in the hedge fund and managed funds industry. I am also vice-chairman and co-chief executive officer of Millburn Ridgefield Corporation, which since 1971 has managed money in the currency and futures markets and sponsored fund of funds and equity hedge funds.
MFA appreciates the opportunity to testify before this committee on the Report of the President's Working Group on Financial Markets concerning the public policy implications of the recent events involving Long-Term Capital Management. MFA commends the committee for its continuing interest in the impact of LTCM on the health and stability of the U.S. and world financial markets. MFA congratulates the Working Group on its extensive review of the LTCM events. In brief, MFA believes that the report is a constructive contribution to the debate concerning the public policy implications of the events surrounding LTCM. MFA concurs with much of the Working Group's analysis and many of its recommendations. However, MFA believes that certain of the recommendations for further Government action do not satisfy the tests of efficacy and avoidance of undue costs advocated in the report itself. MFA urges this committee and other public policy makers to be skeptical of purported solutions to the LTCM ''problem'' that consist of creating yet another Washington information ''warehouse'', which is unlikely to advance the important task at hand of improving credit assessment and risk management by lending institutions and financial market counterparties, such as those who extended credit to LTCM.
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I will address these points briefly in my testimony and note that MFA has also submitted for the record its own report on the public policy implications of LTCM.
In many respects, the Working Group's conclusions on the public policy implications of LTCM accord substantially with those of a number of other valuable analyses undertaken to date by regulatory organizations and the MFA in its own report. Like MFA's report, the Working Group's Report underscores several key points, which I also highlight here:
First, LTCM was an extreme, apparently unique, case. It was distinguished by the scale of its activities, the large size and illiquidity of its positions in certain markets, and the extent of its leverage. If it had twice the capital - or half the leverage - events imply it would have weathered the storm. A fund pursuing the same strategies without the total assets and leverage of LTCM would have posed no systemic risk, and we probably wouldn't be here today. LTCM was not typical of hedge funds. The concerns as to size and leverage raised by LTCM are more aptly associated with other types of large institutional traders, such as the proprietary trading desks of commercial and investment banks, than with hedge funds generally. The Working Group Report recognized this.
Second, the Working Group's Report stresses the extent to which LTCM was permitted to attain its extraordinary market positions by laxity in credit risk assessment and monitoring of lenders and other counterparties. If LTCM was a credit addict, the lenders supplied the drugs. The report underscores that ''LTCM seems the extreme case that illustrates the inherent weaknesses of some prevailing credit practices.'' LTCM achieved its extraordinary size and leverage due largely to deficiencies in credit risk management practices by its lenders and counterparties. In particular, in managing the LTCM relationship, banks and dealers relied on significantly less information on financial strength, leverage and liquidity than they normally require, due apparently to the reputation and laurels of the principals, LTCM's mystique, and the profits to be earned by handling its trades. The awe in which LTCM was held has no precedent and is unlikely to be seen again.
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Third, credit risk management is the preferable tool for constraining the type of market activity illustrated by LTCM. No substitute exists for rigorous risk management by lenders and counterparties, who have both the incentive and the ability to obtain and assess the complex of risk-relevant information necessary to assess and monitor their exposure to hedge funds and other borrowers, highly leveraged or otherwise. The individualized risk management of lenders and counterparties is a key foundation for management of risk in the financial system generally. As the Working Group noted, ''the exercise of credit discipline in trading relationships has the potential to provide a balance between the benefits and risks of leverage.'' Following LTCM, regulators and supervisors have made significant progress toward assuring enhanced effectiveness of credit risk management by lenders to entities such as LTCM. Public policy initiatives relating to hedge funds should focus on identifying sound credit practices and fostering their implementation.
Fourth, direct regulation of hedge funds is not warranted. For the reasons stated above, efforts to fortify market discipline to prevent credit lapses such as occurred in the case of LTCM should be the focus of regulatory and industry initiatives. Before any direct regulation of hedge funds is pursued, the difficulties of formulating an effective regulatory approach that does not create more public costs than benefits should be fully considered. MFA strongly agrees with the Working Group's conclusions that the primary mechanism that regulates risk-taking by firms in a market economy is the market discipline provided by creditors, counterparties and investors. Moreover, the voluntary industry initiatives described in appendix F to the report are strong evidence that the financial services industry has the motivation to improve market stability and efficiency through self-regulation and has undertaken important initiatives to the end. This refutes an implication in the report that market participants are motivated only by self-interest and have no concern about the health and stability of the markets. As a general matter, as the report stresses, Government regulation of markets is properly achieved by regulating financial intermediaries that have access to the Federal safety net, that play a central dealer role, or that raise funds from the general public. These factors do not characterize the hedge fund industry. If the lenders to LTCM had been doing their job properly, the LTCM problem would not have occurred.
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I also wish to highlight MFA's views on several other aspects of the Working Group's Report.
First, the critical role of private sector initiatives to enhance risk management practices. MFA believes that the private sector initiatives underway or contemplated to address the risk management issues raised by LTCM are critically important and strongly supports those efforts. In particular, MFA wishes to voice its support for the report recommendation that a group of hedge funds develop a set of sound practices for their own risk management and controls. Hedge funds currently devote extensive attention and resources to their own internal controls and risk management. Development of ''best practices'' guidance for the industry can only enhance these efforts. MFA endorses the Working Group's recommendation and is prepared to take a leadership role in such an initiative, which would include representation from throughout the hedge fund industry. MFA also supports the efforts of the Counterparty Risk Management Policy Group, comprised of twelve major internationally active banks and securities firms, which is developing standards for strengthened risk management practices for banks, securities firms, and others providing credit to major counterparties in the derivatives and securities markets.
Second, the report's recommended disclosure and reporting requirements lack utility and impose undue costs. MFA supports the objective of increased transparency in credit relationships between lenders and hedge funds and other borrowers, as recommended by the extensive guidance issued to date by the banking regulators and endorsed by the Working Group. MFA believes that this objective is best advanced by the credit practice enhancements recommended to date by Federal, state and international banking regulators and the private sector initiatives underway to strengthen the credit risk management process. MFA does not believe that the report's recommendations for more frequent or augmented reporting by commodity pool operators and hedge funds to regulators and the public respond to the concerns raised by LTCM or otherwise satisfy the standard set forth in the report that ''Government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes.''
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Both the utility of such regulatory and public reporting to its intended recipients and the potentially adverse impacts of requiring it deserve serious attention. Reports to the public would appear to be inconsistent with the private nature of hedge fund offerings, as defined by fundamental regulatory constraints under the securities laws precluding advertising and public solicitation, and would invite public competition among entities whose regulatory status is premised on the private conduct of their business. Further, the information that would be reported would be of highly questionable utility to its recipients. The report suggests that the recommended disclosures include value-at-risk reporting, which generally does not reflect the type of extreme market fluctuations which imperiled LTCM, or stress test results, which cannot be readily interpreted without significant explanatory material. How much stress should be hypothesized? Interest rates go to zero or 30 percent overnite? Put in enough stress and every strategy fails. Snapshot quarterly data presumably would be intended to capture complex portfolio risk data in a public report but are as likely to distort as to advance understanding and hold real potential for inducing a false sense of security, or concern. Such reporting also would direct attention to inherently stale data that do not provide a solid basis for assessing the risks of a given fund and may, in fact, have the perverse effect of creating a false sense of assurance concerning the condition of a fund. Of course, there is also the burden to be considered. My firm operates 11 futures funds, 3 hedge funds and 2 fund-of-funds, so we now prepare 16 annual reports. This would become 64 reports. I don't know if I want to get to know the auditors that well. We would be happy to do it but only if a material benefit could be demonstrated.
Further, and perhaps most importantly, a new disclosure framework of the nature contemplated would not help to provide a solution to the concerns the report itself identifies as central to the LTCM event. It would not be designed—nor would it serve—to augment the risk management of the parties who made possible LTCM's markets positions. It wold not enhance the quality of the lending and counterparty relationships that are key to the concerns presented by LTCM. Every counterparty my firm has positions with marks them to market daily. These lending and counterparty relationships will not be served by a newly devised information ''dump'' on the public and the regulators; they require the close review of a complex of individualized, risk-related data—more comprehensive and timely data than any public reporting system is or should be calculated to produce. What would the SEC or CFTC do with all these reports, much less the public? Evaluate the wisdom of complex trading strategies? I doubt it. Finally, additional disclosure requirements of the nature proposed may create incentives for funds to move offshore to jurisdictions without such requirements—ultimately creating unintended, negative consequences for U.S. regulators seeking to manage systemic risk. As Chairperson Born of the CFTC stated earlier, offshore hedge funds with no U.S. investors would not be required to file reports, so at best, only a partial picture of hedge fund activities would emerge from the reports.
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In conclusion, MFA applauds this committee, the Working Group, regulators and market participants who have acted in the wake of LTCM to identify the causes of the LTCM events and to foster, initiate and promote actions to rectify lax practices, fortify risk management best practices and improve supervisory oversight. MFA urges the committee and other public policymakers to avoid ''quick fix'' legislative or regulatory solutions that do not address the fundamental risk management issues presented. Only by requiring market participants to bear the burden of risk management, with the guidance and encouragement of public overseers, will the most enduring and effective ''best practices'' be implemented. We believe that the efforts of public and private sector groups to develop more effective, sophisticated and rigorous risk management practices should be the central focus of regulators and the marketplace in seeking to reduce the potential for future market disruptions.
June 14, 1999
THE HONORABLE TOM EWING
Chairman
Subcommittee on Risk Management, Research and Specialty Crops
House Agriculture Committee
Washington, DC 20515
DEAR CHAIRMAN EWING,
The undersigned farm organizations respectfully request the following be made part of the permanent hearing record for the subcommittee's June 8,1999 hearing.
We urge changes be made by the Commodity Futures Trading Commission (CFTC)to improve the Agricultural Trade Options pilot program and that serious consideration be given to the following suggestions as a means to stimulate participation in the program, while ensuring an adequate level of regulatory oversight to maintain the program's integrity.
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1. Registration. A simplified registration system should be developed within the CFTC. Such a system should require a minimum level of financial safeguards and/or a bonding requirement to protect customers and reduce the likelihood that unscrupulous individuals will qualify as agricultural trade options merchants (ATOM S). In addition, a full range of dispute resolution options should remain available to contract participants ranging from arbitration under industry trade rules to CFTC reparations actions.
2. Reporting. The current pilot program operational rules concerning reporting, recordkeeping, risk disclosure and transactional confirmation are burdensome, expensive and provide limited security for parties to an ATO. We believe these rules could be substantially simplified while maintaining the ability of the CFTC to obtain the data necessary to fulfill its regulatory responsibilities and provide pilot program oversight. In addition, while customers
should have access to their AT0 transaction records and receive a written confirmation of any trade option contracts, the notification requirements of the pilot program could be significantly reduced.
3. Cash Settlement. n previous correspondence with the Commission, we outlined the need for a voluntary cash settlement provision for agricultural trade options. While we share the concern that cash settlement should not be used as a vehicle to speculate in this market, we continue to support some form of cash settlement opportunity to reflect the production and market realities of agriculture. We would be supportive of a limited cash settlement provision that restricted utilization to a one-time opportunity, or required other conditions prior to exercising that option.
4. Speculation. The rules established for the pilot program do not permit producers to sell covered calls presumptively due to the increased risk that could be undertaken. We remain uncertain as to the cost/benefit of such a prohibition for agricultural producers. Thus, until a convincing argument can be provided for waiving the existing rule, we support its continuation.
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5. Exemption Level. The current rules allow for an exemption from regulation for those parties to an AT0 that have a net worth of $10 million or greater. It has been suggested that the exemption level should be reduced to $1 million to be consistent with other off-exchange market exemptions. Providing an exemption from regulation will create a competitive inequity across the merchandising sector. In addition, an exemption would likely reduce the available data necessary for the Commission to review and provide oversight for the pilot program. We believe that if other regulatory modifications can be implemented to reduce the cost and simplify the process to encourage participation, an exemption at this time is unwarranted.
Sincerely,
American Farm Bureau Federation, American Soybean Association, National Association of Wheat Growers, National Cattlemen's Beef Association, National Corn Growers Association, National Cotton Council of America, National Farmers Union, National Grain Sorghum Producers, National Pork Producers