I appreciate Tom Sexton and the Chicago Bar Association’s Futures and Derivatives Committee providing me this opportunity. After law school, when I moved to Chicago to study for the Illinois Bar, I joined the Chicago Bar Association symphony orchestra as an extra-curricular exercise. I don’t think I was an official member of the Chicago Bar Association—I guess when you need trombone players, you let some rules slide. But I thoroughly enjoyed the social aspects of the organization and wished I had stayed in Chicago long enough to partake in more weighty legal discussions. Well, here I am today to discuss one of those weighty topics: the Commodity Futures Modernization Act. I hope to provide you with some background on the policies and events behind its passage, whether the CFMA has lived up to its billing and what changes might be necessary during the next Congressional reauthorization. Before I begin, I would like to make the standard disclaimer that the views I am about to give are mine alone and do not represent those of the Commission or its staff.
History of the CFMA
On December 21, 2000, President Clinton signed into law the Commodity Futures Modernization Act (CFMA). This bipartisan legislation was the most sweeping overhaul of the Commodity Exchange Act (CEA) since the creation of the Commodity Futures Trading Commission (CFTC) in 1974. The CFMA’s general design sought to bring greater competition and innovation to the various derivatives markets and to build a more predictable and calibrated regulatory oversight apparatus. In meeting these goals, the CFMA provided legal and jurisdictional certainty to the OTC derivatives market, reformed the regulatory structure for futures exchanges and their participants, and lifted the ban on security futures products (SFPs), allowing these products to trade under the joint supervision of the CFTC and the Securities and Exchange Commission (SEC).
The CFMA’s passage in 2000 was somewhat miraculous given the various competing financial interests and the uncertain political landscape. The key congressional members involved with crafting the legislation understood that any one opposing force could derail the bill’s passage in a shortened Presidential election year, as was the case in 2000. The futures exchanges and the Wall Street banks had traditionally viewed each other as competitors, vying for the same derivatives business. Each was unwilling to allow the other a unilateral legislative victory. This tension required those in Congress writing the bill to seek out a consensus designed to balance and offset these competing financial interests.
The political uncertainties during this time were unprecedented in American history—the 2000 election was indeed a political “perfect storm.” Just prior to the election that year, Congress adjourned until after Election Day to finish its business for the year in a special lame-duck session. The strategy was that the election would tilt the budget debate to favor one party over the other. Instead of clarification, however, the election brought political chaos. The presidential contest resulted in a deadlock with no declared winner for over a month. With the Senate evenly split, the control of the Congress also lay in the balance until a President was declared and the Vice President could assume the tie-breaking role of president of the Senate.
It should be of no surprise to this audience involved in the risk management business that this environment of extreme political uncertainty would lead risk adverse individuals to hedge their bets. And that’s exactly what they did. The mid-December evening upon which a final legislative deal was struck on the CFMA was the same night that Vice President Gore withdrew from the presidential election. Within days, the CFMA had passed as part of the final legislative vehicle enacted into law that year. While we now take for granted the progressive dynamic created by the CFMA, we shouldn’t forget that this legislation very nearly didn’t pass.
The foundation of the CFMA was built on resolving the “legal certainty” problem that had plagued the OTC derivatives market for over a decade. The CEA--the statute authorizing the CFTC’s governance of the futures markets--dates back to 1922 when Congress brought agricultural futures into a modern regulatory structure. The CEA requires that the trading of all futures contracts occur on a registered futures exchange under the exclusive jurisdiction of the CFTC. This regulatory structure was designed around the traditional “open outcry” exchanges to ensure that standardized, intermediated futures trading occurred in specific physical locations under the watchful eye of a federal regulator. This regimented oversight also took aim at off-exchange “bucket shops,” in which individuals would fraudulently solicit funds from customers for futures trading and then pocket or “bucket” the money for themselves. Requiring that futures trading occur on a registered exchange among registered brokers greatly minimized this illegal activity.
However, as the OTC derivatives market began to develop over the last twenty years, it became apparent that the regulatory model for futures trading was ill-fitted for these products. It is true that the economic functions of OTC derivatives are similar to futures contracts. Both seek to transfer undesired economic risk from one party to another who is willing to accept it. Unlike standardized futures contracts, however, OTC derivatives are not traded on registered futures exchanges but are tailored transactions designed and brokered for sophisticated counterparties through regulated Wall Street institutions. Traditionally, U.S. banking regulators have had jurisdiction over the banks trading the vast majority of these instruments.
In 1998, the CFTC began to take steps suggesting the agency was on a path to asserting its exclusive jurisdiction over OTC derivatives to the exclusion of other Federal regulators. Requiring these tailored transactions to trade on a CFTC-regulated exchange would have drastically changed the fundamental characteristics of the OTC market. Market participants also feared that if the CFTC claimed jurisdiction for OTC derivatives, existing transactions could be deemed illegal off-exchange futures contracts under the CEA, allowing a court of law to declare the contracts null and void. Such a ruling could have reverberated throughout the entire OTC derivatives market by allowing parties to walk away from unprofitable OTC derivatives obligations.
In November 1999, the President’s Working Group on Financial Markets (PWG), which consists of the principals from the Department of Treasury, the Federal Reserve Board, the SEC and the CFTC, unanimously proposed a report clarifying the jurisdiction of the CFTC by excluding certain OTC derivatives from its oversight. The PWG had been created after the stock market crash of 1987 to facilitate an open dialogue among federal financial regulators when inter-market issues arise. In determining the appropriate scope of CFTC jurisdiction, the PWG report looked to whether the products were being traded by retail customers, whether the products were susceptible to price manipulation and whether the participants were not otherwise regulated. Unless one or more of these attributes were present in the market, the PWG believed that there was no policy justification for providing the CFTC with oversight.
Congress incorporated the PWG reasoning in the CFMA through several different exclusions. To address the highly liquid OTC financial marketplace, the CFMA excluded from the CFTC’s jurisdiction financial products that are traded among large market participants, defined as eligible contract participants (ECPs), as long as the trades are not transacted on an exchange-like trading facility. Given the low probability that these liquid financial instruments could be manipulated, the lack of retail participation and the ongoing oversight by other financial regulators, Congress agreed with the PWG that there was no policy justification for providing CFTC jurisdiction over these transactions.
The Act also excluded from CFTC oversight financial products traded on an electronic trading facility if the transactions are entered into on a principal-to-principal basis by ECPs. In addition, the CFMA excluded from CFTC jurisdiction the electronic trading facilities upon which these products are traded. Electronic exchanges were thought to be less susceptible to wrongdoing thanks to the real-time audit trail created by these platforms. Congress also prohibited brokered trades as a condition to these exclusions, believing that participants trading for their own accounts were more accountable when their own wallets were at risk.
The CFMA also made an important clarification regarding the CFTC’s jurisdiction over retail foreign currency futures and options contracts. Prior to the CFMA’s enactment, the statutory interpretation was unclear as to whether the CFTC or the U.S. Department of Treasury would oversee futures and options transactions on foreign currencies, making it difficult for the CFTC to bring fraud actions against off-exchange foreign currency scams aimed at retail customers.
The CFMA adopted language generally excluding from the CFTC’s oversight foreign currency transactions not transacted on a registered futures exchange. However, where off-exchange retail foreign currency futures or options transactions are offered to retail customers, the Act clarified that the CFTC does have jurisdiction unless the offering firm is an “otherwise regulated” entity. The Act further clarified that the CFTC’s anti-fraud authorities apply to off-exchange foreign currency transactions that futures commission merchants (FCMs) and their affiliates enter into with retail customers. These changes largely plugged a loophole that had allowed off-exchange retail foreign currency bucket shops and boiler rooms to exist and flourish.
The CFMA also provided legal and regulatory certainty for exempt OTC commodity transactions and markets. The Act defined “exempt commodity” as a commodity that is “not an excluded commodity or an agricultural commodity.” In practice, this definition primarily encompasses energy and metal commodities. Unlike statutory exclusions where the CFTC retains no authority or jurisdiction over transactions, an exemption retains for the CFTC certain residual authorities while serving to clarify the areas of the law that no longer pertain to a given transaction.
The CFMA exempts from broad CFTC authority transactions in exempt commodities that are entered into by large market participants and not traded on a trading facility. However, the exemption reserved CFTC certain anti-fraud and anti-manipulation authorities over these exempt transactions.
In addition, the CFMA provided an exemption, found in section 2(h)(3) of the CEA, for transactions in exempt commodities traded on an electronic trading facility as long as they are entered into on a principal-to-principal basis among large commercial entities in the commodity business. As part of the 2(h)(3) exemptions, the transactions are subject to anti-fraud and anti-manipulation authorities of the CFTC. In addition, if the electronic trading facility upon which these exempt contracts are traded becomes a significant price discovery market, the CFTC may also prescribe rules on the timely dissemination of pricing data and trading volume and information. The comment period just ended on a proposed rulemaking of the Commission detailing the possible means for accomplishing this requirement.
The 2(h)(3) exemption also requires an electronic trading facility relying on the exemption to notify the Commission of its intention to operate; to provide the names of the facility; to describe the types of commodity categories being traded; to identify its clearing facility, if any; to certify that the facility will comply with the terms of the exemptions; to certify that the owners of the trading facility are not otherwise statutorily disqualified under the CEA; to either provide the Commission with real-time access to its trading system and protocols, or provide the CFTC with such reports as it may request; to maintain books and records for five years; to agree to provide the Commission with specific information on a special call basis; to agree to submit to the CFTC’s subpoena authority; to agree to comply with all applicable laws and require the same of its participants; and to not represent that the facility is registered or in any way recognized by the CFTC. Although not fully regulated like designated contract markets, this laundry list exhibits that the CFTC retains a certain amount of oversight over these exempt markets.
Regulatory Reform for the Futures Industry
In regards to on-exchange activity, the CFMA provided a new regulatory structure for the futures exchanges and their participants. The Act laid out differing tiers of regulation for exchanges, depending on the types of products being traded and the level of sophistication of the participants trading them. Futures on commodities of finite supply that are more susceptible to manipulation and are offered to the retail public, such as agricultural futures contracts, are required to trade under the more heavily regulated “contract market” designation. Those instruments that are less susceptible to manipulation and are offered only to sophisticated investors and institutions can benefit from a lighter regulatory touch by trading on a designated “Derivatives Transaction Execution Facility” (DTEF). The CFMA also allowed exchanges that might otherwise qualify for an exclusion from the Act to opt to be an “exempt board of trade,” the lowest tier of regulation by the CFTC. The intent behind the tiered regulatory structure was to allow exchanges to innovate more rapidly to meet competitive challenges while enabling the CFTC to tailor its regulatory focus to those areas requiring greater government scrutiny.
The CFMA also transitioned the regulatory structure of the CFTC from prescriptive rules and regulations to one using a principles-based approach. This is similar to the regulatory regime used by the Financial Services Authority in Britain. Instead of specifying the means for achieving a specific statutory mandate, the CFMA set forth core principles that are meant to allow participants in these markets to use different methodologies in achieving statutory requirements.
To satisfy these core principles, the CFMA encouraged the development of “best practices.” Allowing the industry and self-regulatory organizations, rather than the CFTC, to develop their own standards and guidelines was thought to better promote the practices reflective of the marketplace. The CFTC ultimately retains the authority to approve such practices, but the genesis for such guidelines is derived from the marketplace rather than the traditional top-down regulatory structure.
The CFMA provided exchanges with authority to implement new products and rules without prior CFTC approval through a self-certification process. In self-certifying a new rule or product, the exchanges must provide the CFTC with a written declaration that the new contract or rule complies with the Act and the CFTC’s regulations. These changes were seen as necessary to allow exchanges the ability to react quickly to the competitive challenges anticipated by the Act.
The CFMA required for the first time that clearinghouses receive their own separate designation as “derivatives clearing organizations” (DCOs) before providing clearing services. Like exchanges, DCOs must abide by a separate set of core principles that are tailored to the specific risks associated with these entities. The Act, as recommended by the PWG report, also enabled registered DCOs to clear excluded OTC derivatives in an effort to reduce counterparty and systemic risks for these transactions.
Security Futures Products
The CFMA lifted the statutory ban on security futures products (SFPs), which had been in place since 1983, and provided a joint regulatory framework between the SEC and CFTC for allowing the trading of these instruments. The Act provided the CFTC exclusive jurisdiction over futures on broad-based security indexes. For futures on single securities or on narrow-based indexes, known collectively as security futures products or SFPs, the CFTC and SEC have joint jurisdiction over these instruments as both futures and securities. In an effort to avoid duplication, the Act provided a mechanism to allow exchanges and firms to choose a primary regulator and a secondary “notice-regulator.”
The SEC/CFTC regulations to implement this joint oversight for domestic SFP trading took almost two years after the CFMA’s passage to complete. But in November 2002, two domestic exchanges, NQLX and OneChicago, began trading these products. Both exchanges are registered as designated contract markets with the CFTC, and are notice-registered as securities exchanges with the SEC. Although volume has been modest in these markets to date, it is very early in the product lifecycle to predict whether it will succeed in the long run.
Has the CFMA Worked?
The question before us today is whether the CFMA has succeeded in achieving its goals. Has it promoted greater competition? Has the CFMA enhanced innovation? Has the CFTC become a more effective and tailored regulator? Although I think it is difficult and potentially premature to judge the long-term effectiveness of the Act, the consensus thus far among the industry has been very positive. Congressional testimony by members of the futures industry in June 2003 thoroughly praised the CFTC and the regulatory framework created by the law that has allowed this sector to compete and thrive.
Since the CFMA’s passage in late 2000, volume on exchange-traded futures and options has increased by 113 percent. This compares with a 7 percent increase in the three years preceding the Act. The OTC derivatives market also has grown exponentially since the CFMA’s enactment with the notional value of contracts up by 50 percent. Undoubtedly, these markets are succeeding within the framework of the legislation.
What better anecdotal evidence of the enhanced competition anticipated by the CFMA than the clearing link that was established last summer between the Chicago futures exchanges. Competitive forces have shifted the cost-benefit paradigm of the exchanges. Mutual survival has become more important than the long-standing differences that had kept the exchanges apart over the years. Competition is extremely effective at focusing businesses on their core missions, as was the case here. The result was a clearing link that will add value to both Chicago exchanges, create capital efficiencies for firms, and strengthen the risk profile of the marketplace as a whole. And this beneficial change occurred as both exchanges reduced fees.
Another barometer of competition is the number of competitors vying for exchange business. Prior to the enactment of the CFMA in December 2000, there were 12 registered futures exchanges in the United States, and a majority of these exchanges had been in existence since the 19th century. Since the CFMA, the CFTC has designated six additional futures exchanges as contract markets, and another eleven exchanges are set to operate as exempt markets subject to limited CFTC oversight. In addition, the Commission will hold an open public meeting tomorrow morning in Washington D.C. to decide the fate of the USFE application. And I haven’t even mentioned the OTC market, which provides similar risk management products as the exchanges. Clearly, competitive forces are present in this sector.
Product innovation is another goal of the CFMA worthy of study. The three years leading up to the CFMA saw 175 new products approved by the Commission with an average approval time of 90 days for futures contracts and 60 days for options contracts. Post CFMA, 458 new products have been listed by exchanges with a vast majority being certified by the exchanges for immediate trading. Nearly half of the new products listed were security futures products made lawful by the CFMA. Innovation is occurring at a record setting pace, spurned by security futures products and the product certification tools made lawful by the CFMA.
These statistics and other anecdotal evidence indicate that the barriers to entry for exchanges have been lowered by the CFMA, and opportunities exist for enhanced competition to thrive in these markets. Laws cannot guarantee competition but they can be tailored to maximize competitive opportunities. At a minimum, the CFMA has done just that.
What to expect in reauthorization?
The CFTC will need to be reauthorized in 2005. Reauthorization has traditionally provided Congress with an opportunity to address concerns about the workings of our statute. Gazing into my crystal ball, I would like to provide a guess of what areas might be studied.
Since the last reauthorization, corporate scandals have rocked the financial markets, primarily on the equity side of the ledger. Nevertheless, Congressional policy makers for the futures industry should rightly explore whether our statute or regulations need to be adjusted to detect and deter such corporate wrongdoing.
Specifically, one area worthy of discussion is self-regulation in the context of corporate governance. The CFTC staff is in the midst of a study on self-regulation that will make findings and recommendations to the Commission in the coming months. And I praise the forward thinking of some of the exchanges themselves that have made changes in their board structure to eliminate conflicts between their regulatory functions and their profit centers. However, I believe our statute could be clearer regarding the objectives that are expected of self-regulatory organizations. Just as core principles have provided public guideposts for contract markets and clearing organizations, they could serve a similarly important function for self-regulatory organizations. Self-regulatory core principles would provide exchanges and registered futures associations with concrete public directives while allowing them the flexibility to structure their organization to meet specific business needs. It would also offer the CFTC a template when its staff conducts compliance audits on such organizations. As government and public institutions continue to study this issue, including our own agency, I am confident that a logical and well-founded outgrowth of such deliberations will be core principles for self-regulation.
I also believe that Congress should study the adequacy of our fraud and manipulation authorities. The very nature of the risk markets has changed. Most of the new electronic exchanges coming online are not brokered transactions, but principle-to-principle trades. Yet our statute’s anti-fraud authority only applies to intermediated trades—the infamous “for and on behalf of” language. There are no policy justifications that I have heard that would argue against extending these authorities to principle trades. As a result, I believe our Act should be amended accordingly.
The collapse of Enron and other problems in the energy-trading sector have highlighted the potential need for clarifications to our fraud and manipulation authorities in the area of OTC transactions in exempt energy commodities. Congress continues to explore whether additional authorities, if any, are needed by the CFTC and other Federal regulators to ensure that OTC energy trading remains free from fraud and manipulation. To the credit of our enforcement staff, our agency has used its authorities to settle 13 energy trading cases for over $180 million in penalties, and I expect these enforcement actions will serve as a deterrent for similar behavior in the future. But without having tested our authority in a court of law, there remains some uncertainty to whether energy transactions are excluded from our Act, in which case our fraud and manipulation authorities would not apply, or exempt from the statute, in which case we retain certain fraud and manipulation authorities. I believe that such important clarifications are worth exploring.
In closing, I appreciate the Chicago Bar Association for inviting me to speak here today, and look forward to any questions you might have.
Last Updated: July 22, 2007