Discussion on Deregulatory Initiatives - Contract Market Designation and Exchange Rule Changes
Paul Architzel, Chief Counsel, Division of Economic Analysis 13

John Lawton, Acting Director, Division of Trading and Markets 29

Discussion on CFTC Reauthorization Issues - November 1999 Report of the President's Working Group on Financial Markets
C. Robert Paul, General Counsel, CFTC 62

Break 99

Briefing on Revised Corn and Soybean Delivery Terms and Deliverable Supplies of Genetically Altered Commodities
David D. Lehman, Group Manager - Commodity Products, Market & Product Development Department, Chicago Board of Trade 103

Briefing on Agricultural Trade Options Final Rules
Paul Architzel, Chief Counsel, Division of Economic Analysis, CFTC 133

P R O C E E D I N G S

WELCOMING REMARKS AND INTRODUCTIONS

COMMISSIONER SPEARS: Good afternoon. I think we'll go ahead and get started.

Again good afternoon. I'd like to welcome you all to the 27th meeting of the CFTC's Agricultural Advisory Committee. At the outset, let me say how much the commissioners and the staff of the CFTC appreciate the time and effort all of you have given to this committee.

The agricultural markets represent a vital segment of the Commission's regulatory responsibilities and present us with unique issues and challenges. The two-way dialogue between the Commission and this committee is a vital resource to this agency as we move forward into the future, as well as to the industry as a whole.

Today we stand at a critical crossroads--critical for the CFTC, critical for the markets we regulate, and critical for the producer and agribusiness organizations represented on this committee who depend on these markets for hedging and price discovery.

Next year, as the CFTC once again comes up for congressional reauthorization, this agency will be 25 years old and the statute we administer, the Commodity Exchange Act, will be 78 years old. Those years have seen some profound changes.

For example, at one time the vast majority of the contracts traded on the U.S. domestic exchanges were agricultural contracts whereas today that volume represents about 15 percent of the volume of futures and options. In addition, U.S. domestic exchanges face an increasing global competition from foreign exchanges and the over-the-counter market. Also, changes in technology and the development of electronic exchanges have also created new challenges and opportunities.

All of these changes have forced us, including the CFTC, its congressional oversight committees, and market users, to rethink how we do business. We must fashion a statutory and regulatory system that makes sense in today's world. We must allow the U.S. exchanges to compete in the global financial marketplace without unnecessary regulatory burdens. But we must also do so without abandoning appropriate protections for market users and the farmers, businesses and consumers who depend on these markets for price discovery.

Under Chairman Rainer's leadership, the Commission has already taken some significant deregulatory actions. Today's first agenda item deals with two recent initiatives: final rules allowing exchanges to list new contracts for trading without prior CFTC approval, and a proposal that would allow exchanges to make new rules and rule amendments effective without prior CFTC approval.

The second agenda item deals with potentially even more profound deregulatory concepts contained in the November 1999 report to Congress by the President's Working Group on Financial Markets. The recommendations in that report are expected to figure prominently in the upcoming CFTC reauthorization.

The deregulatory initiatives we'll be discussing today could have a significant impact on agricultural markets. It is important for the members of this committee to share their views, their questions and their concerns about these issues with the Commission. I urge all of you to take full advantage of that opportunity this afternoon.

Before we go to the first agenda item I'd like to introduce the Commission's new chairman, Chairman Bill Rainer, for any comments he might have.

CHAIRMAN RAINER: Thank you very much. I also want to add my welcome to everyone around the table and tell you how much I appreciate your taking the time to come here today.

I thank Commissioner Spears for organizing this event. It's a very timely event because we're in this information-gathering and -synthesizing period, which is a process that has included, among other things, three public meetings. The first one was last Thursday, where we had a general roundtable of a number of interested parties and participants to discus the general ideas of regulation in today's environment.

Yesterday we had a technology roundtable with about 33 or 34 people involved with technology in one form or another to discuss the impact of technology on the futures business and the regulation of the futures business.

And today we have the Agricultural Advisory Committee to discuss similar topics that surround our reauthorization. This is a very important constituent group of the CFTC and we want to hear your views.

With that, I'll turn the floor back to Commissioner Spears.

COMMISSIONER SPEARS: Thank you, Mr. Chairman.

I'd also like to introduce my other fellow commissioners here today. Commissioner Barbara Holum, do you have any comments you might want to make?

COMMISSIONER HOLUM: Thank you. I would just like to join in welcoming all of you, as well. As the chairman said, we are in the mode of listening and we're happy to be here and hear of your concerns and your ideas about the future. Thank you.

COMMISSIONER SPEARS: Thank you, Barbara.

Commissioner Newsome?

COMMISSIONER NEWSOME: Thank you, Commissioner Spears.

Again I appreciate everyone taking the time and effort to attend this meeting. I know that for many of you it's time away from your business, but it is critically important to the CFTC because this business is changing ever-rapidly; technology is driving a lot of these changes and we look at changes in competition, changes in risk and manipulation and potential changes in regulatory needs.

So the Commission is going to have to face some very difficult questions, questions that could impact the ag markets and we need your help in answering those questions.

So I appreciate you being here today and hope that you will get fully engaged in this process. Thank you.

COMMISSIONER SPEARS: Thank you, Jim.

And finally, Commissioner Tom Erickson, who's been new to the Commission since this committee last met. Tom joined the Commission, I believe, in June?

COMMISSIONER ERICKSON: Yes.

COMMISSIONER SPEARS: So welcome, Tom. Any comments?

COMMISSIONER ERICKSON: Thanks. I just would also like to extend my welcome to everyone around the table. It's good to see how many old friends, I guess, and I'm looking forward very much to hearing the interaction today between you and staff and others here and look forward to working with each of you as we move forward in new directions and in the legislative arena, where we will very likely see some changes. I look forward to hearing from you. Thank you.

COMMISSIONER SPEARS: Thank you, Tom.

I'd also like to maybe go around the room here and have the various committee members introduce themselves just quickly and the affiliation, who you represent, what commodity group or organization. So we'll start with you Rick.

MR. KERWIN: I'm Rick Kerwin. I'm representing the National Grain Trade Council.

MR. LYONS: I'm Dave Lyons. I'm representing NAEGA.

MR. OLSON: Ron Olson. I'm with General Mills Minneapolis, representing North American Millers' Association.

MR. WHITE: Robert White, National Grange.

MR. SHAW: I'm Dan Shaw, representing the National Grain Sorghum Producers and I'm taking the place of Bill Kubecka for today.

MR. DODDS: I am Bill Dodds, representing the National Grain and Feed Association.

MR. MILLER: I'm Jim Miller with the National Farmers Union.

MS. KEITH: Susan Keith with the National Corn Growers Association, filling in for Glenn Moeller.

MR. WILSON: I'm Lemmy Wilson, National Cattleman's Beef Association.

MS. ASKINS: I'm Mary Helen Askins, Independent Community Bankers, and I'm filling in for Mark Scanlan today.

MR. GILLEN: I'm Neal Gillen for the American Cotton Shippers Association.

MR. FRANCL: My name is Terry Francl. I'm with the American Farm Bureau Federation and I'm filling in for Ed Wiederstein today.

MR. METZ: Good afternoon. I'm Bob Metz with the American Soybean Association.

MR. ROENIGK: Bill Roenigk with the National Chicken Council.

COMMISSIONER SPEARS: Again, I thank all of you for being here.

Just a quick housekeeping chore. Most of you know that after you speak into these microphones, you have to turn it off because you cannot have more than two or three are on at the same time.

I'd also ask, for the benefit of the reporter who is transcribing the meeting, when you do ask a question or speak, would you please speak into the microphone? Thank you.

We'll go ahead and get stated. First, let me also real quickly just acknowledge the efforts of my staff in putting together this meeting. Jennifer Roe, my administrative assistant, who did most of the work of putting the meeting together. I also want to acknowledge Alan Ott and Don Heitman of my staff, who's also been very helpful. Most of you already know them.

With that, we'll go ahead and go to the first agenda item. I'd like to ask Paul Architzel, chief counsel of the Commission's Division of Economic Analysis, to discuss the new contract designation rules. Following that, John Lawton will come forward and also brief the committee on the rule amendment, proposed rule.

Again, we'll go ahead and discuss any questions or comments you might have after each of the presentations. Paul, I'll go ahead and turn it over to you.

DISCUSSION ON DEREGULATORY INITIATIVES CONTRACT MARKET DESIGNATION

MR. ARCHITZEL: Chairman Rainer, committee chairman Spears, commissioners and members of the Agricultural Advisory Committee, good afternoon. I'd like to brief you on a recent change in the way the Commission oversees the introduction of new exchange contracts and amendments to those contracts.

This change will provide significant and important regulatory relief to U.S. exchanges. It will also change. It will also change the way that the Commission carries out its regulatory mission in this area. It will not, however, change the substance of the requirements that new and already listed contracts have to meet under the Commodity Exchange Act.

This change was proposed by the Commission on July 27, 1999. The Commission adopted the final rule on November 26, 1999 and it goes into effect on January 25, 2000.

This new rule is a sweeping and dramatic change from current procedures. Currently, the Commission reviews and approves applications for new contracts under regular review procedures, which takes, on average, somewhere between three to three and one half months to complete. We also have fast-track procedures where the review process is completed in either 10 or 45 days, depending upon the nature of the contract. Under both of these procedures, the contract is not permitted to be listed until after the Commission has approved it.

The new procedure, which becomes effective on January 25, permits futures exchanges to list new contracts by exchange certification. Under this procedure, futures exchanges would not be required to submit new contracts for Commission review and approval before listing.

The certification procedure requires futures exchanges to file with the Commission the text of the contract's terms and conditions and the exchange's certification that the contract does not violate nor is inconsistent with the Act or Commission rules. The exchange must also, in its rules, identify the contract as solicited for trading, pursuant to exchange certification. The exchange may list the new contract for trading the following day.

All futures exchanges that previously have been and are designated by the Commission as the contract market may use this listing procedure. The only limitations on the next-day listing procedure are one, it cannot be used by a competitor to beat to market a contract which has already been filed with the Commission for regular or fast-track review and is pending for Commission action.

Two, it cannot be used as a way to evade an adverse Commission proceeding, such as a Commission action to disapprove or modify an existing contract.

And three, it cannot be used for stock index contracts.

Exchanges also may amend the rules or conditions of these contracts through a similar certification procedure. They may change contract terms the day after filing with the Commission the text and a brief explanation of the change and the exchange's certification that the exchange rule is consistent with the Act and Commission rules.

In order to provide greater legal certainty to market users and consistent with current exchange practice, contract changes can be implemented only beginning with trading months having no open interest. Legal certainty is further reinforced by a provision of the Commission's rule that specifically provides that contracts listed by exchange certification are not void or voidable due to a violation by the exchange or by any action of the Commission to disapprove, alter or supplement any of the contract's terms.

Listing new contracts through exchange certification is an alternative to the current procedures for regular or fast-track prior review and approval by the Commission of new contracts. However, in a rule proposal that will be discussed next by Mr. Lawton, we ask whether we should use this new procedure exclusively. We also request comment on whether the requirement that changes apply only to months with no open interest needs to be explicitly retained.

In order to level the playing field between the two methods of introducing new products, the Commission has proposed to eliminate designation application fees. Eliminating designation application fees would remove a potential financial penalty on exchanges that wish to submit new products for prior Commission review and approval.

Although listing new contracts by exchange certification fundamentally redefines the relationship of the Commission to the exchanges in the introduction of new products, there's a logical outgrowth of the Commission's successful experience in administering fast-track contract approval which requires that contracts be submitted in final form and not amended during their review.

Listing new contracts by exchange certification recognizes the great strides that the exchanges have made in fulfilling their self-regulatory obligations over the past 25 years. It also respects the exchange's role as a regulatory partner to the Commission under the Act's scheme of providing government oversight of industry self-regulation.

Although radically redefining the procedures for bringing new contracts to market, listing new contracts by exchange certification does not lower the regulatory requirements for contract design; nor does it reduce your role. The Commission stands ready to pursue vigorously its oversight responsibility of the exchanges' surveillance functions, which include the responsibility to appropriately design contracts.

Moreover, in carrying out its oversight, the Commission will continue to seek out and be responsive to the views of interested members of the public regarding the design issues for both existing and newly listed contracts alike.

In this regard we intend to upgrade our website to better notify the public of new contracts or contract amendments made by exchange certification and to seek input on them directly from the public. When appropriate, we will use our oversight authorities to address any problems with such contracts or rule changes.

The Commission is confident that in this way we can lighten the regulatory burden on U.S. futures exchanges while, at the same time, achieving our regulatory mission.

I'd be happy to answer any questions.

COMMISSIONER SPEARS: Are there any questions or comments regarding this final rule? Neal.

MR. GILLEN: Paul, I'm going to jump ahead to proposed rule for contract rule changes without prior approval of the Commission. There's a definite distinction in the final rule and the proposed rule in that in the final rule, a contract can be traded without prior approval of the CFTC and presumably those in the marketplace will determine whether or not the contract's going to trade and whether or not it's acceptable to them.

The distinction that I'm alluding to is in the proposed rule, which says that the submission would have to include a brief explanation of the rule and a description of any substantive opposing views expressed by members of a contract market or others with respect to the rule.

That's sort of a go-and-stop type of situation. How do you explain the difference in the two proposals?

MR. ARCHITZEL: One of the differences is that when we receive a rule amendment, the same way when there's amendment on legislation that those of you who work on the Hill are aware of, it's sometimes hard to piece together the effect of the proposal.

When you get a new contract, the terms and conditions are laid out and it's quite easy to understand what it's doing. On the other hand, when there's an amendment, it's sometimes necessary to receive an explanation of what's happening because you may only be seeing deletions and additions of separate provisions.

Secondly, in the context of a rule amendment there are already interests that are trading that instrument and therefore, if there are opposing views, it's important for us to know that in our oversight capacity so that we can follow up on those rules.

MR. GILLEN: As a follow-up to that, do you factor in the fact that an exchange committee and an exchange board of governors has reviewed those objections and still went ahead further, still went ahead with the change? Is the Commission still going to, in effect, make the final determination as to what is good for a particular contract?

MR. ARCHITZEL: I don't think that the Commission will make the determination of what is good for a contract. I think the Commission only will make a determination on whether or not a proposal meets the requirements of the Act, and that's our obligation as the oversight regulator.

To the extent people in the trade, such as yourselves, have views on whether or not a contract meets that requirement, it's important for us to be informed about that and we look to the trade. I know you're all aware we often do trade interviews to understand the impact of changes to terms and conditions, and that certainly will continue.

Our role is not to micro-manage the contracts that are offered by the exchanges but rather, to ensure that those contracts meet the design requirements that are put forth in the Act.

MR. GILLEN: If I could make a further comment, I understand that, but when you get to the issue of delivery points, as the Commission experienced last year, people from up the Avenue get involved and I would hope that the Commission--after reading Chairman Rainer's speech in Chicago, he made it quite clear that the Commission was making what I call a right turn and toward the market dictating what the rule should be.

I would hope that the Commission would give a little more influence to the market, as opposed to Capitol Hill, on contract terms and conditions and contract rules.

MR. ARCHITZEL: Certainly that was an issue where there were many views expressed by the industry. We had somewhere over 600 or 700 comments filed in the course of that entire rulemaking.

You may remember, and it's a long time ago but that started out simply with a request by the Commission that the exchange address the issue without a requirement that it be addressed in any specific way.

So I think, as I noted earlier, the success of this approach depends upon a partnership between the exchange and the Commission and part of that partnership, I think, and part of the oversight by the Commission, it's the receptivity on the other side to requests to address problems.

COMMISSIONER SPEARS: Lemmy.

MR. WILSON: Did I understand correctly that once a contract is created, it cannot be changed at all?

MR. ARCHITZEL: Correct. However, of course, if an exchange feels that an immediate change is necessary, it can always list an A and a B contract so that people wanting to get into a new contract are able to do so immediately.

MR. WILSON: My concern is that once you've gotten into a contract and used it as a pricing mechanism, it can't be changed on that given time frame, that it has to be a month that doesn't have any trading in it.

MR. ARCHITZEL: That's correct, except in an emergency situation.

COMMISSIONER SPEARS: Bob.

MR. WHITE: I'd like to ask the question you made reference to the point about vigorous oversight. What provisions have you made to have vigorous oversight?

MR. ARCHITZEL: I think we have a large surveillance staff that surveils for maturing futures in particular and for pricing anomalies. As part of that, we will also surveil, as part of that function, contract terms and conditions to determine whether or not those terms and conditions somehow contribute to pricing misalignments, and that will continue.

In addition, the staff that we have that currently reviews new contracts that are submitted will be looking into those contracts that are listed under the new procedure and determining whether or not there are issues.

In addition, we will be providing this information on our website so that we do have an availability to get information from the public, to notify us if they see problems with the contracts or with specific terms and conditions that we can then follow up on.

COMMISSIONER SPEARS: I might just add that as you mentioned, Paul, this new final rule does allow the exchanges the opportunity to use the existing regular approach that we've had in the past, as well as the fast-track approach.

From that standpoint, Paul, it might be helpful for this group if you can enlighten us as to, in the past, the breakdown between the exchanges' use of the fast-track process and the regular approach and the difference between them. The way I understand it, basically now we have the opportunity for them to have a contract designated, as opposed to trade in a certified contract. So can you expand on both those points briefly?

MR. ARCHITZEL: I think currently about 50 percent of the contracts which are filed are filed under regular procedures, as opposed to under fast track procedures. Now some of those contracts are not eligible for fast-track procedures because they involve stock index contracts and the regular procedures involve an opportunity for the SEC to have a look at those contracts and to take action on them.

Of the remaining contracts, those that would be eligible for fast-track, exchanges may choose to submit them for regular review and there may be a variety of reasons, one of which may be they're still discussing the terms of the contracts and they may be subject to change during our review period.

It may also be that the contract involves coordination with another government agency. If it's on some kind of commodity that's regulated by another regulator, it may be that there needs to be coordination by us with that agency or with a foreign government. And in those instances it makes more sense for it to be approved by us under regular procedures.

The last difference is that the Commission, in approving contracts, looks at the anti-competitive nature of any provisions of the contract and makes the determination on that and imbalances the policies of the Act against the policies of the anti-trust provisions. And some contracts don't raise issues like that and therefore are appropriate for fast-track review.

Other contracts which may issues along those lines, the exchanges may want to submit to us for our full review so that we can make that anti-trust determination, and that insulates the exchange from subsequent challenge on anti-trust grounds.

COMMISSIONER SPEARS: Are there any other comments or questions regarding this final rule before we move to the proposed rule change? Bill.

MR. DODDS: Just for the record I have a statement here but I'm not going to read it. Generally we support the direction you're going, even as it relates to amending the rules.

One question I had was the open interest question. That was answered.

I have copies. I have ag trade option stuff attached to it. At the end, you can pick up a copy.

COMMISSIONER SPEARS: Thank you. Anybody else?

If not, I'll go ahead and ask John Lawton to come forward and talk about the proposed rule for exchange rule changes.

While he's coming forward, I'd like to take time just real quickly to introduce two guests that have recently joined us from the Hill. I'd like to introduce Lance Kotchworth who's the chief counsel of the House Ag Committee staff sitting over here. Beside him is Ryan Weston, who most of you know works with Chairman Ewing's staff and heads up the subcommittee for Chairman Ewing.

So with that, we'll go ahead and turn it over to John for his presentation and then questions and comments regarding the proposed rule change for exchange rules.

EXCHANGE RULE CHANGES

MR. LAWTON: Thank you, Commissioner Spears.

Good afternoon. Section 5(a)(12) of the Commodity Exchange Act requires that contract market rules be submitted to the Commission for prior review. Commission reg 1.41 sets forth the procedures for exchange submission and Commission review. It generally provides for review periods of 10, 45 or 75 days, depending on the type of rule.

The proposal that was recently published would establish an additional procedure. Subject to stated conditions, the proposed regulation would permit contract markets to place new rules and rule amendments into effect on the business day following their receipt by the Commission.

I'm going to first outline the features of the proposed regulation and then identify several issues raised in the proposed request for comment.

Starting with eligibility, to be eligible for the procedure, a contract market would have to be designated in at least one nondormant contract. Thus the Commission would continue to conduct prior review of new exchanges to ensure that their trading and clearing systems and their self-regulatory programs complied with the Act and Commission's regulations.

The proposed submission requirements are pretty straightforward. An eligible contract market would simply file one, the text of the rule or amendment with additions and deletions indicated; two, a brief explanation of the rule amendment; three, a description of any substantive opposition expressed by members or by others; and four, a certification that the rule is not inconsistent with the Commodity Exchange Act or with the regulations.

Thus the regulation 1.41(z) procedure would not be available for contract market rules that, in the absence of some type of Commission exemption, would violate or be inconsistent with the Act or the Commission's regulations.

The rule or amendment could be placed into effect the day after Commission receipt of the submission.

Under this proposal the Commission would retain the authority to disapprove or to alter a rule that is provided for under existing sections of the Commodity Exchange Act. The proposal provides, however, that a transaction executed subject to a rule implemented under this procedure would not be void or voidable as a result of a violation by the contract market of the requirements of the procedure or by the initiation of a Commission proceeding to disapprove the rule. This provision is intended to provide legal certainty to market participants that the validity of their transactions won't be called into question after execution because of a problem with the contract market rule that was submitted under this procedure.

As I mentioned, the draft Federal Register release identified a number of issues on which public comment is requested. First is the exclusivity of the regulation 1.41(z) process.

As previously noted, Commission regulation 1.41 currently provides procedures for prior Commission review and approval of exchange rules. The existence of these various rule review procedures could create confusion for market participants about the regulatory history of particular rules or lead to an inaccurate impression that rules adopted pursuant to the new procedure had been approved by the Commission.

The release that we published would request comment on whether the proposed rule review process and the concurrently adopted process for contract market designations that Paul just described should be the only available processes rather than alternatives to the existing processes for approving rules and new contracts.

The second question raised in the release relates to potentially suspending the effectiveness of a rule. The Act generally requires notice and opportunity for hearing before a rule may be disapproved or altered. This process can be quite lengthy. Market participants and others adversely affected by a particular rule could incur harm during this period. Therefore the proposal requests comment on whether the Commission should reserve authority under this regulation to stay or to suspend the operation of a contract market rule once the Commission has initiated proceedings to disapprove or alter it.

The third issue relates to contracts with open interest. This is related to the one I just discussed. A rule change implemented under the proposed rule could have an impact on market participants holding open positions. The proposed release asks whether this process should be available for rule amendments that relate to contracts with open interest at the time the rule is implemented.

The fourth area raised for comment relates to exchange emergency rules. In the Futures Trading Practices Act of 1992, Congress established a special process for the implementation of emergency rules. By permitting an exchange to place rules into effect without prior review, proposed regulation 1.41(z) may make it possible for an exchange to take emergency action outside those procedures. The release requests comments on how an exchange emergency rule provision can be differentiated from other rules that could be adopted pursuant to proposed regulation 1.41(z).

The final topic addressed by the release is new electronic trading systems. Implementing a new trading system is in some ways similar to organizing a new exchange. The release requests comment on whether proposed rules implementing a new electronic trading system at an existing contract market should be eligible to be processed under this proposal.

Commission staff encourages all the members of the agricultural community to express their views on these or any other issues raised by this proposal during the comment process. Thank you.

COMMISSIONER SPEARS: Thank you, John.

We'll now open the floor to any questions or comments regarding this proposed rule. Keep in mind the last rule we talked about was a final rule the Commission adopted November 17. This is a proposed rule put out for public comment, I believe for 60 days. So at this point in time any comments or views would be very timely as the Commission considers final action on this proposed rule. So I open the floor to any questions or comments.

Terry.

MR. FRANCL: Dave or John, I guess concern would be in the area of the contracts with open interest, to what extent could those be changed and would they affect the contracts that currently had an open interest--I guess by definition, the ones we're talking about.

MR. LAWTON: As drafted, the proposed rule does not differentiate and essentially all exchange rules that they feel that they can certify are consistent with the Act and the regulations are eligible under the procedure, as drafted.

MR. FRANCL: So could you give us some potential examples? I mean could there be a change in the delivery provisions, for example?

MR. LAWTON: Yes, there could.

COMMISSIONER SPEARS: John, it might be helpful and I know that Neal alluded to a contract where there was some controversy; terms and conditions changed, soybeans and corn contract delivery terms earlier.

MR. GILLEN: Cotton, too.

COMMISSIONER SPEARS: And a cotton one, as well. I wasn't going to mention that one.

Then I think there are issues like that, so it might be helpful if staff or Paul or John might come forward and just give some history. It might be helpful for this group as it relates to some of the changes in the past or some potential new contract rules or changes that may be pending that may be affected by this proposed rule.

MR. ARCHITZEL: Sure. The way it's currently structured is the final rule that the Commission proposed relates only to new contracts which are listed pursuant to this new procedure. And in that rule it requires that any changes be applied only to those months without open interest. The exchanges have said that that is their normal practice in any event.

The Commission, because it was a final rule, determined it was better to be somewhat cautious and to make it an explicit requirement that that be the way new changes be put into effect.

In the proposed rule there's an opportunity for the public to comment on whether or not this is such an important consideration that it should be included as a provision of the rule.

Now the Commission didn't propose to include that as an explicit requirement on the basis that the exchanges have said their normal practice is not to apply changes to existing contracts. Some kinds of changes, such as to trading systems, may be put into effect against new contracts and it doesn't really affect the value of the contract. For example, if they had some kind of new trading system or moved it to an electronic platform it wouldn't necessarily affect the value of the contract.

Those provisions that you're most used to focussing on are those provisions which affect the value of the contract and because the proposed rule is drafted to not differentiate between those two types of rules, it does not explicitly require that the rule be implemented only with respect to contract months that don't have open interest. It's certainly something that the public can comment on and it's as much a drafting matter of the rule as anything else.

COMMISSIONER SPEARS: Jim.

MR. MILLER: Would it be possible to draft a rule that only applied to those issues that wouldn't affect the contract value? Or is that something that would be so difficult to, first of all, draft and enforce, that you wouldn't do it?

MR. ARCHITZEL: I think it is possible to draft it. We do currently distinguish those types of rules based upon under the old system, whether it was a 141(b) or a 141(c) rule, which is somewhat technical, but it's not a drafting problem; it's a question of philosophy. And the exchanges have said their practice as a self-regulator is not to put contract terms into effect against months that have open interest where those terms make a difference in the value of the contract.

The question is whether or not our rules need explicitly to prohibit them from doing something they said they would do already. That's something that I think the Commission has expressed interest in receiving comment on.

COMMISSIONER SPEARS: Neal.

MR. GILLEN: We had a conundrum in the cotton contract a few years ago when we had a rapid increase in price, I guess '96-'97, and they increased the margin requirement retroactively. That caused a lot of heartburn to the small and medium-size merchants and their bankers.

So how would you address a retroactive situation?

MR. ARCHITZEL: Margins are one area of contract rules that the Commission does not review or approve except for stock index contracts, in which case in those contracts, that authority for review of margins is assigned to the Fed, which is then delegated to the Commission.

There would be no change in the status quo because we don't have authority to review margin rules.

MR. GILLEN: I might add that given the rise in price, the action could be argued as justified, but some folks just didn't understand that.

MR. ARCHITZEL: Well, I guess that's something Congress has chosen not to bestow that authority to the Commission and for those people who feel we should have it, I guess the argument is there.

COMMISSIONER SPEARS: Jim.

MR. MILLER: What's going to be the process for public notification and comment? It seems to me that you have the potential for an exchange to come up with a rule change and notify the Commission to implement a day later, yet many of the people who rely on the function of the exchange are not day-to-day participants in the activities in the exchange. In many cases they're not participants in the exchange of traded products at all, even though the price discovery function has a dramatic impact on them, on their economic well-being.

MR. ARCHITZEL: I think part of that will depend upon the due diligence of organizations like your own. We intend to have that kind of information on our web page. It will be available. I think that currently we publish that information in the Federal Register. Is our web page less effective in reaching you all than the Federal Register is? We'll make it available; it will just be in the form of our web page.

MR. MILLER: Maybe I'm misunderstanding the proposed rule but it seems to me you're only going to know 24 hours in advance of when it goes into effect and yet you're requiring the exchanges to be able to offer an expression of those that may be opposed to the rule change. What opportunity is there going to be for people that are not direct participants in exchange activities to present the opposing view, so to speak?

MR. ARCHITZEL: I think that the Commission certainly seeks out the viewpoints of the public in a lot of different means, one of which we do roundtables when there's an issue facing the markets which is a broader issue.

We also do trade interviews when we think that there's an issue that needs to be addressed that we identify. And we're also open to receiving comment from the public.

If there's a change in a contract and it's noted that members of the board have disagreed with it and we've asked that for notification as part of the explanation that we're going to get, that's a signal to us that we need to look at that closing. And in that case, in addition to publishing it on our website and waiting for people to comment on it, we also would be conducting trade interviews.

MR. LAWTON: I would just also add that there's also a matter of exchange due diligence here. I think they should be seeking out the comments of interested parties before they submit these rules.

COMMISSIONER SPEARS: Susan.

MS. KEITH: Yes, Commissioner.

I think that although we would like to take a lot of comfort in what is the practice of the exchange with regard to making changes that would affect the value of the contract, that it would be prudent to preclude that under this kind of rule, that it seems to me that there's no damage to be done by precluding any changes under a very expedited procedure or something that the exchanges say they aren't going to do anyway. And if we rely on what is the practice, that we risk being surprised later.

And even though the market will sort itself out in a relatively short amount of time, with the commodity contracts, even a very short term shock to the market, to the contract, can have devastating impacts on farmers and on the perception of the role of the exchange in price discovery, and that has long-term implications in how the farmers that rely on the exchanges for price discovery think about those markets.

So I don't see that the risk of relying on the practice outweighs the relatively, what I would see as the minor step of precluding something that the exchanges will say they wouldn't do anyway because it's not normal practice.

COMMISSIONER SPEARS: Ron, then Rick.

MR. OLSON: I would be in favor of letting the exchanges do it. I guess I speak--I'm a member of all three exchanges. I was chairman of Minneapolis for three years and on the board for 18 years and understanding the procedures and the due diligence that an exchange goes through and the amount of comments they solicit, even when you review what they did with corn and Chicago, corn and bean delivery rules, that was a long, long-term process that the industry evaluated. It was very public.

And I think with the Commission having oversight over this whole issue, I don't see any exchange doing anything that's going to run counter to that oversight and create a situation like occurred on corn. It will be well discussed ahead of time.

I also think, you know, the exchange is entering a new competitive environment. With the electronic age and the ability to communicate worldwide and trade contracts worldwide by anyone, I think there's a real feeling that you have to trust that the people that are actually doing the market, trading the market, which includes producers and users and the whole industry, are making value judgments on what is good for the contract because it runs through a contract committee, it runs through the board, it's got to be voted on by the membership.

There are several layers of action that have to take place before a rule exchange can even take place in an exchange. And I think if there's any controversy associated with it at all, the exchanges are either going to go to an A and B contract or they're going to do what they say they do in practice, is we will only implement that rule on a contract with zero open interest.

So I would be in favor of letting the exchanges make this rule, as long as the Commission retains its oversight rule.

COMMISSIONER SPEARS: Rick.

MR. KERWIN: I would agree with what Ron said and only add that really if you limit it to contract with no open interest, you're in effect making it like a new contract. And as people have said, it would sort itself in due course if the rule was a truly economic one.

So I think, too, that the exchanges in the competitive environment that they're in could be well served to have as much flexibility as they can and by not having it affect contracts with open interest, I don't see that it would have a materially adverse effect on the agriculture community.

COMMISSIONER SPEARS: Ken. Most people know Ken Ackerman. Ken joined us late. Ken Ackerman, for those who don't know, is the administrator of the Risk Management Agency over at USDA. Ken.

MR. ACKERMAN: Thank you, David. I apologize for being late.

Just on this particular point, I think the issue that John Lawton raised at the beginning about emergency rules is very instructive in this discussion. Traditionally, some of the rules that have been most controversial have been those that have been adopted in the heat of a breaking situation, and that is where you've had the most concerns raised about it being market-sensitive or about there being conflicts of interest, those kinds of things. Clearly in the final rule, dealing with that issue will be very important.

I just want to say as a general matter I think it's a very healthy, favorable thing that the Commission is working on these rules and has put these on the front burner. It sends a very good signal. Obviously there are some very thorny issues. There are some very difficult issues. These are questions that have been wrestled with over a period of decades. There's lengthy literature on all of these.

But the fact that these are being put on the front burner in a way to try to see if there are ways to maximize the flexibility that exchanges have to function as self-regulatory bodies while still maintaining the Commission's role as overseer is a very important function and I applaud the Commission for doing it.

One question I did have, in reading Chairman Rainer's speech at Chicago Kent, the distinction was made between financial contracts versus contracts dealing with tangible commodities. Has that distinction entered into this discussion and how so?

MR. ARCHITZEL: It has not in the final rule that the Commission adopted and it has not in the proposed rule.

COMMISSIONER SPEARS: Paul, it might be helpful, or John--Terry, have we answered your question of a while ago? You asked for some examples of contracts when you first spoke up.

From what I understand, the issues that might be important to this committee might be such things as spec limits. You mentioned delivery terms and conditions.

Paul, can you think of any other examples that this proposed rule might effect? Can we give real-life examples for this group?

MR. ARCHITZEL: I think many of the terms in guideline number 1 are ones that might have an impact. In addition, for example, to delivery specifications, there might be a change in the cash settlement procedures, anything having to do with the valuing in the contract, delivery locations, grades, discounts, premiums.

COMMISSIONER SPEARS: Jim, go ahead.

MR. MILLER: Given the fact that we're going to discuss ATOs in the not too distant future, what impact do you see this rule having on the operation of the agricultural trade options in terms of a farmer entering into an option with a merchandiser sometime during the year and then, later in the year, and I'm assuming that a merchandiser is going to use the exchange to pass off his risk and that sometime during the year the rules change?

MR. ARCHITZEL: Well, under the rule that the Commission already adopted, the final rule, it's not possible for the exchange to have changes to the contract be adopted on those months that have open interest.

So to the extent the ag trade option merchant is writing contracts only on those months that already are listed, it shouldn't have any effect because the value of the contract that he's entered into on the exchanges cover for his off-exchange contract which he wrote, should remain constant.

COMMISSIONER SPEARS: Ron.

MR. OLSON: Just one other minor comment. If you're going to put a rule in that impacts value, since it's a zero sum game, that means half the people in the exchange or half the open interest is impacted. So if it affects value, the exchanges are not going to implement it on a contract that has open interest because half the people will vote against it, so it won't pass. It won't get through the system.

The oversight role with the Commission stating that we want to hear the objections and the dialogue, they're also going to get involved with that and I don't see an exchange that's going to want to go to battle in that kind of an environment.

So if it affects value, the exchange will automatically go to an A and B contract or to contracts with open interest because you can't get it through the system that exists from the due diligence part of an exchange.

MR. ARCHITZEL: I think occasionally the disagreement has been whether or not the change will affect value. For example, if someone is a hedger and there's a change to the contract terms, they may find themselves out of position and it may affect their basis.

So it may not have as widespread an effect as some types of changes would but it may affect certain individuals who were hedging based upon a basis relationship.

COMMISSIONER SPEARS: Ken.

MR. ACKERMAN: Just a question on that. If that were the case and an exchange board were to take a vote that could potentially change the value of an open contract, would not the conflict of interest rules governing the exchange kick in, requiring disclosures or whatever rules are in effect?

MR. ARCHITZEL: John.

MR. LAWTON: Yes, I think they would be applicable.

COMMISSIONER SPEARS: Neal.

MR. GILLEN: I might add that hypothetically you could have a situation where the distant months, say there was no open interest, would make a change. Say we could make a change in the base grade and you could argue that this would preclude someone from rolling the contract over, in which you'd have to take delivery on the last contract. If there's a significant change of grade, we may even have to go to a new contract. That problem could be there.

COMMISSIONER SPEARS: Terry.

MR. FRANCL: Let me just bring up what I think is a possibility and that's the issues we have with biotechnology of crops now--if there's a grade question, whether or not that would become part of the specification. Then I think Neal's comments are very appropriate because you could virtually be precluded from rolling from one period to another.

So while that's something that wouldn't occur often, it still merits some consideration.

COMMISSIONER SPEARS: Chairman Rainer.

CHAIRMAN RAINER: My intention today is to be a net if not an absolute listener and I'm learning a tremendous amount, but I didn't want Ken's question to go by the board without my making some comment.

We're anxiously going down two parallel paths. They're not parallel; they're separate. One is these two rules, in effect, can be linked to a response to the 4(c) petition, which the exchanges put in this past summer.

The other thing that's going on is a response by the Commission to the recommendations on the part of the President's Working Group with respect to over-the-counter derivatives, and that path is the path where we're reviewing aggressively and in some detail about how to provide the appropriate relief, if necessary, to the exchanges in the instruments that are directly implicated or involved as a result of what we're doing in the over-the-counter derivatives market.

So that's still a work in process item.

COMMISSIONER SPEARS: Any other questions or comments regarding this proposed rule? Jim.

MR. MILLER: I don't want to belabor the point but I guess I'd like to ask Ron a question.

He's suggesting, as I understand it, that since there would be people on both sides of the issue, the exchange would never approve a rule change that affected value. So you're suggesting that any of these rule changes that might be proposed would not affect basis?

MR. OLSON: No, I think basis is part of value, so the people that trade are commercials and specs and a mix of both those. Hedges are involved, as well, and the exchanges are very sensitive to what's going on in a market. I mean they're the experts in saying what makes this market better and how do we respond to the future and make the market better, either for competitive reasons with other exchanges or, I think as Terry brought up, the biotech world.

There's a lot of things now that are being handled over-the-counter because the exchange contract doesn't match up with the segregation that's starting to go on in various grains. So this gives the exchanges the freedom to respond better to the market and make sure the contract follows and actually reflects what the true market really is. So it's not burdened by a change that comes there.

But I do go back to the point that if value is affected, whether it's in the contract itself or in the spreads or in the basis, the exchanges know that very well and if people are against it, those comments will be public and will be passed on to the Commission in their oversight role.

MR. MILLER: But that would also, going back to Susan's comment, suggest that there shouldn't be opposition then to prohibiting changes that affect the value if they're not going to happen anyway. Is that correct?

MR. OLSON: I think it ties to Paul's comment. The exchanges will have a flavor of whether it affects value or not. My point is if it does affect value, the exchanges will go to a contract with zero open interest or they'll go to an A-B contract concept.

COMMISSIONER SPEARS: Bill.

MR. DODDS: I guess I would just report that personally, as a member of the Chicago Board of Trade, number one, they have a long track record of not changing terms that affect value.

Number two, they have a long track record of industry participation. As related to corn and beans, I was part of the committee that worked for a year and a half--we spent a lot of time at the board hammering out what we should or shouldn't do and we didn't all agree.

Now that the soybean contract is gone and the new one's here, markets have adjusted rather well on the new contract. That's my first report. And we're more supportive of letting the board of trade get closer to the market, and there's a responsibility with that. They need to bring in more of the industry and listen to what the industry has to say, I think, if they want to be less regulated.

COMMISSIONER SPEARS: Lemmy.

MR. WILSON: First of all, we're kind of concerned about if there is a change in the value of the contract, it does disturb us.

Secondly, on the other side of this coin, we've been trying to get some changes made to where we can deliver efforts, and some of these things we can't get one thing done; that's our problem.

COMMISSIONER SPEARS: Susan, go ahead.

MS. KEITH: I guess I also take exception to the use of the term "it's a public decision." We're talking about a private exchange making a private decision. They may engage the various sectors in that decision-making or they may not, but it's a private decision that we're talking about; it's not something that's open for public comment.

COMMISSIONER SPEARS: In that regard I might just throw out on the table just for discussion purposes, does anyone's feelings change in regard to this issue around the table if the exchanges demutualize and become for-profit private corporations, as opposed to a member organization, as they are now? Does that change the scope or the scheme of the argument? Jim.

MR. MILLER: I don't think it would affect my members use of it. They're taking the result of what happens in the exchange in many cases. Even though they don't even have a contract, they're subject to the whole gamut of price discovery and what that means in terms of their cash market price at their local elevator or their local merchandiser.

So whether the exchange is publicly traded wouldn't make any difference to them. It's the other end of the transaction that matters to those people.

COMMISSIONER SPEARS: Ron.

MR. OLSON: I assume the Commission oversight role would be identical, so I don't see any change in the organizational structure.

MR. ACKERMAN: The only potential difference I could see would be if it changed the legal liability of the board in its decision-making function if it were to make the exchange board of directors more liable for a negative impact of its decision to the public.

MR. GILLEN: I'd just make an observation, following up on what you said and what Susan said, that exchanges are sort of quasi-public, as I view them, but it's probably the most discordant group of people that could be assembled in any given exchange and it's a tremendous amount of give and take and arguments continually over terms and conditions of contracts and disputes with board traders and commercials.

So I don't think it would make much of a difference whether they were public or private. Most farmers perceive them to be profit organizations and that's a euphemistic term. I think the exchanges do an exceptional job in the price discovery.

I think the caveat that you threw in the proposal, seeking comment on whether or not changes should be permitted if there was an open interest is a valid one. To many of us here it is a no-brainer. It's a no-brainer because of what Ron said, because the exchanges do the due diligence. Occasionally poor people prevail over commercials, and, representing commercials, we view the Commission as the court of last resort.

So we value a voice here, as a farm group.

COMMISSIONER SPEARS: Other questions or comments on the proposed rule change?

As Neal just pointed out, we at the Commission are looking forward to the comments on this proposed issue as we make our final decision during the next few months on the final rule. And I think that as John pointed out, we asked for comment on two or three key questions. As you said, Neal, open interest is one of those issues.

So I think to this commission and I think all the commissioners at the public meeting cited that public comment was going to be a key issue or something that we were going to look very closely at as we made our final determination on this rule. So I would encourage any of the member organizations, not only will your comments at this meeting be part of the record but any individual comment letters or group comment letters, if you will, would be very helpful as we look forward to making that final decision.

Before I close this topic I'll give one last chance for anybody else to make a comment or a question on this particular issue before we move to the next topic.

Just for the record I want to note that in your packet is a statement or letter from National Farmers Organization that outlines their views on this particular issue. They could not be here today but they asked me to make it known that in your packet would be their comments on this proposed rule change.

DISCUSSION ON CFTC REAUTHORIZATION ISSUES - NOVEMBER 1999 REPORT OF THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS

COMMISSIONER SPEARS: If there are no other comments or questions, we'll go ahead then and move on to the next topic on the agenda and that is a discussion and briefing regarding the President's Working Group Report on Financial Markets that was sent to Congress in November or last month that kind of outlined some fairly major deregulatory concepts and outlined a number of issues.

I've asked Bob Paul, who's general counsel to the Commission--Bob's been at the Commission approximately--

MR. PAUL: Two months.

COMMISSIONER SPEARS: Two months. Time flies. It seems like a lot longer than that. Bob comes to us from the private sector. Bob, I know there's a bio of you in the packets but you might just give a quick background of what your background has been and then, if you would please, go into a brief description regarding what the PWG report does say and we're interested--I think this group would be very much interested in discussion regarding potential impacts on the agriculture community as a whole. So thank you, Bob.

MR. PAUL: Thank you, Dave.

I just want to say that I'm delighted that Commissioner Spears invited me to address this group because in my two months here, I've had relatively little communication with the agricultural community and based on my dozen years of practice on the outside in futures, I'm well aware of the fact that the raison d'etre for this agency is agricultural products and continues to be a very important part of our focus. And perhaps with the changes that the President's Working Group have recommended, we'll gain an even greater prominence going forward.

With respect to my background, just to give you a quick thumbnail sketch of what I've been doing, I practiced law in private practice for the first seven years out of law school. Then I spent 10 years at Dean Witter Reynolds as their futures lawyer in-house. Then I spent the last two years as the in-house futures lawyer for Credit Suisse First Boston.

So in both those roles I dealt a lot with the exchanges, with customers, with the trading desks, both in over-the-counter as well as exchange-traded products, and pretty much ran the gamut of all the futures products--ags as well as energies, the financials, metals, for-ex.

In any case, I was also delighted when Chairman Rainer called me back in September and invited me to join this team because I think this is certainly the most exciting place to be working in the futures business right now if you're a futures attorney.

Some of the things that I've been working on since I got here have borne that out in spades. And while Dave asked me to speak about the President's Working Group, it was also in the context of reauthorization.

I'll just say a quick word about reauthorization because there's not a lot to say about it right now other than that right now we have the proverbial gun to our heads, as we seem to operate every few years in this agency.

Our authorization currently expires on September 30 of the year 2000, so it's incumbent upon Congress to reauthorize this agency and the Commodity Exchange Act if it deems appropriate. But don't worry; I understand even if they don't get around to doing it, they're not going to lock up the doors here, so we can continue in our regulatory mode no matter what happens.

But this could be an extremely interesting year on reauthorization by virtue of a lot of the radical changes that are going on in the markets right now, the proliferation and the development of electronic trading, and I think a lot of the issues have been focussed well and articulated and teed up by the President's Working Group on Financial Markets. And I was lucky enough to have the opportunity in my first three weeks here to at least work on the final stages of the President's Working Group report.

For those of you that missed the report or did not want to wade through all 30 pages of it, I'll give you a quick thumbnail sketch of what it represents.

I think it's important to note at the outset of that, picking up on Ken Ackerman's question and the chairman's remarks, that the Working Group Report is really focussed primarily on financial commodities and has a number of carve-outs explicitly for nonfinancial commodities with finite supplies, of which obviously the agricultural products represent a large percentage.

So even though a lot of the recommendations of the Working Group Report do not specifically affect the agricultural markets, I think that the general deregulatory trend that the Working Group recommendations represent and which I think is, in part, in response to the chairman's call for moving this agency from a front-line to an oversight regulator, will obviously have impact on the exchanges that the agricultural commodities trade on, as well as the way that a lot of you do your business.

So the focus is clearly on financials but the impact will be more widely spread. And I think that will be especially apparent in the over-the-counter markets as well, which will continue to develop innovations and electronic trading systems and clearing systems that may not be done necessarily under the auspices of exchanges but that would certainly be open to agricultural commodities, as well.

With that background I'm just going to go through, at the expense of being somewhat tedious, a number of the bullet points that specifically tracks the recommendations of the Working Group, so you'll at least have an idea of what the topography is.

I think it's also important to recognize that I think this report was a response, in part, to the OTC concept release that our previous chairman had issued. Therefore the focus of the report, even though it's the Working Group on Financial Markets and represents all four of the major regulatory agencies, the focus is clearly on the CFTC and the expanse of the Commodity Exchange Act, but it does have implications with the other regulators and the other authorizing statutes.

In any case, in summary, the Working Group had unanimously recommended an exclusion from the Commodity Exchange Act for bilateral transactions between sophisticated counterparties, and that is again only for transactions that do not involve nonfinancial commodities with finite supplies.

It also recommended an exclusion from the Commodity Exchange Act for electronic trading systems for derivatives, provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts again that involve nonfinancial commodities with finite supplies.

You might notice there's a slight nuance between the first two points. In the first case, for bilateral swaps it's between sophisticated counterparties trading as principals. In the second, it's sophisticated counterparties trading their own accounts.

We think that where you have intermediation, we believe that it still warrants some degree of regulation, so at least as a way of dribbling out a deregulatory approach to these markets, we thought it was best to start with a system that is open only to sophisticated counterparties trading on a proprietary basis.

Third, the Working Group recommended elimination of impediments in current law to the clearing of OTC derivatives, together with a requirement that any clearing system for OTC derivatives be regulated by the CFTC, another federal regulator or a foreign financial regulator that satisfies appropriate standards, and I'll come back to that a little bit later. But the crux of that recommendation is obviously that even in the over-the-counter markets, the Working Group members believe that clearing mitigates systemic risk; that's something that should be encouraged and that we deliberately do not want to discourage over-the-counter systems from developing clearing systems simply under the fear that that would bring them under regulation that otherwise they wouldn't be susceptible to.

And last, of the major recommendations is a call by the Working Group to clarify the Treasury amendment that would clear the way for the CFTC to address problems associated with foreign currency bucket shops and would exclude all other transactions in the Treasury amendment products from the Commodity Exchange Act unless they're conducted on an organized exchange.

This is in recognition really of where the case law has been going anyway, where we think that it was a more than equitable trade to yield any residual attempt to establish CFTC jurisdiction over Treasury amendment products in exchange for clear jurisdictional mandate to be able to go after fraud with the retail bucket shops and that's something we felt very strongly about and got full support from the rest of the Working Group.

Having gone through the general overview, I'd like to go into each of those areas with a little more specificity, again tracking primarily what the Working Group said and exactly the way that they said it.

First with the overall carve-out of the nonfinancial commodities with finite supplies, I think the Working Group confirmed what the chairman said in his remarks in his Chicago Kent speech, and that is that we believe that we may not need to assert jurisdiction over financial markets based on the depth, the liquidity and the fact that these markets were generally not used as price discovery mechanisms. We don't believe that that's the case with most of the agricultural commodities.

We recognize that the exchanges continue to serve an important price discovery purpose and therefore we think it's incumbent upon this agency to continue to regulate to ensure the market integrity and that the trading properly reflects the real supply and demand for those products and you can get an accurate read as to what the price should be.

The Working Group also noted that the financials obviously are generally settled in cash, being financials, whereas for the agricultural commodities, delivery is a real part of the contract, that even on the exchanges futures contracts ultimately go to delivery and even with respect to the forward markets, the cash markets, this agency will continue to monitor to ensure that there's no manipulation or fraud that would distort the price discovery function.

I guess also part of the nature of agricultural commodities, as you all well know, is that because it's seasonal and volatile, it lends itself more to manipulation than the financials, which don't have those issues. And probably the agricultural commodities are even more susceptible in that respect than the other nonfinancials, such as energies and precious metals. To some degree they have certain market events happening that can affect supply and demand but we think that probably it's more recurrent and predictable in the agricultural commodities.

So again I think that to the extent that you welcome CFTC regulation, never fear, we're still going to be around. To the extent that you don't, sorry, we're still going to be around.

Specifically with respect to going into the point by point that I enumerated earlier on the swap agreements, I just want to go through with a little bit more detail what that recommendation represents.

First of all, the Working Group recommended that bilateral swaps entered into by eligible swap participants, and currently the Working Group has used as a definition the current eligible swap participant definition, on a principal-to-principal basis, should be excluded from the Commodity Exchange Act provided that the transactions are not conducted on an MTEF, multilateral trade execution facility, because now we're talking about something that starts to resemble exchanges and it could get into the areas of those markets where you're currently regulated and we believe should continue to be regulated.

Nevertheless, there are certain types of electronic trading systems that are in the second point that would be eligible for exclusion from the Commodity Exchange Act and we'll come to that later.

The second observation with respect to swaps is because the material economic terms of many swap agreements are similar, the Working Group has recommended that the requirement under the current swap exemption of the CFTC, that swap agreements not be standardized as to the material economic terms be eliminated. We think that's just a recognition of where the market has been for some time anyway, that although there is a fiction that you can negotiate a lot of the individual terms of swap agreements, typically, as many of you may know, they tend to follow a uniform pattern, helped in large part by the ISDA standard documentation, so to premise any exclusion on the notion that these are actually individually negotiated is somewhat outdated.

So at least with respect to financials, that requirement is recommended to be jettisoned.

Next, the exclusion would not extend to swaps again that involve nonfinancial commodities with finite supplies. So even though we recognize that there is a thriving market in agricultural swaps, the agency would continue to exercise its regulatory oversight over those products and those products would remain subject to the Commodity Exchange Act.

And the last point I'm going to make here is that as I said earlier, the exclusion would cover swaps only between eligible swap participants, and this is in part on the theory that many of these participants are already regulated by one of the federal regulatory agencies and to the extent that they're not, very often they're probably affiliated with one of those regulatory bodies.

Moving on, as I said earlier, I would get into the electronic trading systems because even beyond the general swap exemption, the President's Working Group has recognized that there is the proliferation and rapid development of electronic trading systems that are operating outside the exchanges that are growing in popularity and that in certain cases we believe do not warrant regulation by this agency or any other under the Commodity Exchange Act.

Again however, we think that that blanket exclusion would not extend to agricultural commodities for all the reasons I stated earlier--because of the susceptibility to manipulation, for the need to ensure the integrity of the markets and that the price discovery mechanism even over the counter cannot be manipulated. That could have obviously an adverse effect on the exchange traded pricing, as well.

But just for your general information, to know what the Working Group has recommended with respect to the exclusion for electronics, there are three points. The first is that excluded electronic trading systems would include systems that are clearly not covered by the definition of the MTEF in the current swap definition. Again MTEF is multilateral trading execution facilities. So electronic trading systems that would assist eligible swap participants in communicating or negotiating a bilateral agreement would be permitted.

In addition, excluded electronic trading systems would include any form of electronic trading system, including one in which bids and offers open to all participants--that means actionable bids or offers--provided that the participants in the system act solely for their own account. And again we believe that there's a different level of regulation that's warranted where participants are trading for their own account, as opposed to where they're acting as agents for customers and there's a greater need for customer protection that this agency is not willing to abdicate at this or any time in the future.

And lastly, exchanges that have been designated as contract markets by the CFTC would be permitted to establish these types of excluded trading systems for qualified swaps.

Now this is important to you because even to the extent that your business continues to be done primarily on regulated exchanges, we are leaving the door open for the exchanges to come in and propose markets that operate in essence on an unregulated basis, provided that they meet the criteria that we've set forth, as I described above.

So recognize that this might have impact on the way that exchanges operate in governance issues, that it might affect the revenues that the exchanges might be able to collect in respect to the products other than agricultural. So it might have impact on your business on the bottom line that is unpredictable at this time but I think it's important to recognize that there could be a substantial development of unregulated activity by the currently regulated exchanges. Though it may not directly affect you, it could have some kind of collateral effects.

And I guess lastly, I wanted to talk about the Working Group's recommendations with respect to clearing systems. I think it's important to recognize that what we are contemplating, which seems to be what we've heard over the last two roundtables from industry representatives, is a world where the clearing systems and clearing houses are not necessarily aligned with a particular exchange, that there seems to be a development I think that started more abroad but that's also finding some resonance in the U.S., as well, of an independent clearing house that could service a multiple number of exchanges, as well as over-the-counter markets.

And I think that's where certainly participants in the industry are very interested in moving as quickly as possible because what the intermediaries would like to offer to their customers is cross-margining between the cash markets and the exchange markets and to the extent that you can have clearing houses servicing both exchanges and over-the-counter markets over a variety of different products, it would enhance the ability to deliver to the ultimate end users exactly what they're looking for so that they can maximize use of their collateral and they can also net down their aggregate legal exposure on their open contracts by providing a consolidated clearing house for their various counterparties, as well as for the number of products that they tend to trade in.

So let me just tick off briefly the specific recommendations that the Working Group made with respect to clearing houses.

First is they believe that a comprehensive regulatory framework should contain provisions that would authorize clearing organizations that clear futures commodity options and options on futures also to clear OTC derivatives other than OTC derivatives that are securities, because we still have the SEC to contend with on that issue, and that those could be subject to CFTC oversight.

What we've said with respect in general to clearing houses is that we think by virtue of the fact that they're serving a clearing function that they're going to be responsible for holding customer funds, for ensuring settlement and delivery, that we think that those activities do warrant regulation.

And we think that if it's a futures exchange that is the driving force behind the clearing house or the clearing house is already regulated by the CFTC, we think that should continue to be the CFTC, even if it adds other products to its product mix.

If it's a securities clearing agency that's currently regulated by the SEC that develops the ability to clear other products, then we can see that perhaps the SEC should be the regulator.

If it's some other clearing system that's as of yet undeveloped and not subject to current regulation, then the Working Group has suggested perhaps they organize some sort of a bank affiliate that would be subject to the jurisdiction of the Fed or the OCC. In any case, we want to make sure that one of the major federal regulators would have jurisdiction and we're, I think de facto, suggesting that you may be able to opt into whichever regulator you might prefer by virtue of who your current regulator already is or by what the preponderance of your activity might be.

Moving on, a clearing system subject to regulation by one agency would not become subject to regulation by another agency, and I think that's an important point. So if you do make your choice, if you do pick your regulator, your preferred regulator, you're not going to be necessarily running into multiple regulation by the CFTC, the SEC, the Fed, that you can get one regulator stepping forward to take the primary burden.

And I think the important thing that I alluded to earlier that I want to emphasize here is that the Working Group recommended that clearing through foreign clearing systems supervised by a foreign regulator would be appropriate and that what we have recommended is that the U.S. regulator would satisfy for itself that the foreign regulator applies appropriate standards on its regulation. But, having done that, then we believe that the U.S. regulator should demonstrate comity toward the foreign regulator and that we would not regulate the foreign clearing system in duplicate and triplicate.

So not only do you get a unified system of regulation within the U.S. agencies but we also think that we need to harmonize regulation internationally better and that one way you can encourage clearing on a global basis is to make sure that a clearing house that's willing to take on international clearing obligations is not necessarily exposing itself to a myriad of overlapping, sometimes inconsistent regulations.

Having said that and realizing I've probably used far too much of my time and getting tired of hearing my own voice, I'd like to open this up for questions. I think I've covered everything I wanted to and hopefully you can tell me what things I've missed.

One other thing I want to say before I do turn this over, however, is to come full circle back to reauthorization, if Congress attempted to enact all of the recommendations of the President's Working Group, that would be an extremely ambitious legislative project for them to undertake in the next year. We may get all or part of it.

In the meantime, however, this agency is ready, willing and able to continue to address specific issues that are brought to us by the industry through either our exemptive authority or our ability to issue no-action relief and that we think that in the short run, that will be critical to continuing to encourage innovation and address your short-term needs, rather than waiting for some final legislative response to the Working Group.

So with that, I'll open it up for questions.

COMMISSIONER SPEARS: I might just add that I know Bob covered it in detail and I think that we'd like to get into a general discussion here with the committee members regarding what this means for agriculture.

As I said earlier, this report was sent to Congress in November, this last month, so it's relatively fresh up on the Hill but it was signed by all four members of the President's Working Group, of which Chairman Rainer is one of those members.

And the point that Bob just mentioned, the reauthorization process is just beginning. I know that the various committees on the Hill, including the House and Senate Ag Committees, are very much interested in what this report had to say.

I think equally, from my understanding, they're also interested, as are we at the agency, in what this group, individuals in this room, have to say about this report because I think certainly all of you recognize the role that this agriculture community plays on the House and Senate Agriculture Committees.

So we're looking forward to any comments or views you might have. Certainly as Bob pointed out very well, it does set up to a certain degree a multi-tiered or at least a two-tiered type of regulation system, or proposes that to a certain degree, where you have financials and basically the physicals treated differently from each other as far as the level regulation.

So with that, I'll stop and just open it up for any comments or questions from this group unless Chairman, do you have anything you would want to add?

CHAIRMAN RAINER: No.

COMMISSIONER SPEARS: Okay, comments or questions regarding reauthorization issues as it relates back to the President's Working Group Report or just in general as far as the structure of the markets, level regulation that should be done, as opposed to agriculture markets, as opposed to other types of markets? Bob.

MR. WHITE: What type of benefits do you see coming to agriculture by doing this? Evidently you feel that when you say that we've got to be competitive in the world market and those types of things, are there immediate benefits or is this something that comes gradually? I'd like to hear your comments, when we hear this, that we have to be competitive and there's problems there.

So what would you say would be the benefits that we're going to see from this process?

MR. PAUL: Well, I think there are a few benefits. They're not real tangible probably in the short run but I think one of the benefits in just the process of the Working Group which it was very important for us to reach a consensus with the other members of the Working Group, and that's why these proposals came out where they did. There's some compromise on the part of all sides.

The reason it was important to reach a consensus is by doing that, we believe that we have situated ourselves to be able to take a very meaningful role in the reauthorization process and in working out any improvements to the Commodity Exchange Act, based on our experience of dealing with the industry, that we can ultimately find a way to be more responsive to your needs.

And I think that to the extent that you take me up on my offer and let us know what those needs are, through things like this roundtable and others, I think that we have enhanced our ability to get that message to the Hill.

I think on a competitive level internationally, I think one thing that this agency has long stood for is it's had probably a more international focus than some of the other regulatory bodies. And I think that by sending the message to the other markets around the world that this agency, this chairman, this staff is committed to looking toward meaningful harmonization of the international regulatory framework, that we're going to make our U.S. markets more attractive to the foreign customers, as well as being an integral part of a very well integrated global market.

So through things like enhanced clearing systems that will be able to clear products from various markets around the world through those clearing systems that can do cross-market, cross-product margining and netting, this could also, I think, help a lot of your customers.

And I think that it creates a framework that probably, just by creating more efficient markets in general, I think that the agricultural markets will benefit.

To the extent that it works to your detriment, then I think that this agency would like to know about it and we can make sure that we can address those concerns going forward.

COMMISSIONER SPEARS: Neal, go ahead.

MR. GILLEN: Just an observation. I read the report and I listened to your report because I read it as the worst thing happening was the codification of Shad Johnson, which I think worked well since its adaptation.

Based upon what you just said, I think all the commissioners should go out and get measured for a casket because you're conceding every jurisdiction for a great area of your responsibility and I see more regulation for the agriculture commodities and not less. If you're giving up a substantial area of your responsibility, there's going to be more of a focus on the ag commodities.

A sort of chill went down my back when you alluded to increased oversight into the spot market areas to see if the activity in the spot markets would have any effect on the contract prices.

I just think that when people get together in these study groups, they give the financial markets a free reign and a total free market and then they apply the doctrine of parens patrire to the agriculture community, saying that we have to be oversupervised, but you can have a hedge fund go down the tube, like we had in Connecticut last year, because of banks' failure to exercise due diligence, and this has far more effect on the livelihood of farmers than anything else because the value of their financial instruments takes a dive.

I mean there's a real dichotomy and there's a double standard that is applied in the report and I don't think it's in the best interest of those who are served by the Commission to let the Commission give up a lot of its jurisdiction. I don't think the agriculture committees are going to agree to do that, so your observation that this is all not going to happen I think is probably a prescient one.

MR. PAUL: Well, I'm glad you made those points, Neal, because obviously I misspoke on a lot of issues if I created that impression.

First, I would say that I did not mean to give the impression that by agreeing to limit any of our jurisdiction on these other products that that would lead to greater regulation of the agricultural community. I think the point I tried to make is that the agricultural community would not get as immediate a diminution of regulatory oversight that perhaps some of the other markets have.

However, I think that the agricultural community, as well as all the markets, are going to benefit from a lighter regulatory hand that this agency intends to apply going forward, and I think that that can be demonstrated by the rule changes that Paul and John just spoke about, which do benefit the agricultural products traded on the exchanges, as well as the financials.

So I don't mean to create the impression that because we are quitting the field on certain areas that we don't think warrant regulation among certain participants, that that means that the staff will have a lot more time to focus new attention onto the agricultural markets. And if I gave the impression that we're now going to start regulating the spot and cash markets, then I certainly misspoke on that.

And I think that our mandate is to supervise the futures markets, and I think the extent that the cash markets become important only to the extent that the futures markets can be used as a means to manipulate them, I think that that's the only thing I was trying to say. So I stand corrected and I appreciate you pointing that out to me.

I think overall, though, we're very sensitive to the competitive pressures that all the markets are under, including the agricultural community, and I think that to the extent that if these proposals would have the unintended effect to create a more regulated environment for you, then that's certainly something that we need to understand before we roll out new regulations because that was not the intent.

COMMISSIONER NEWSOME: I wanted to make just a comment with regard to the President's Working Group and financial deregulation.

I think there are a lot of ways to look at this issue and a lot of these ways you look at it tend to make sense. And I think one of the ways that it's been looked at from the ag community is what effect will deregulation have upon ag markets?

But I think just as meaningful is another way to look at it. If we don't deregulate the financial markets, what impact will that have on the ag markets?

I think it's all about competition. Every one of us in this room that are ag producers, we love competition, we love the ability to compete, and that free competition is what has made American agriculture so strong.

Well, the exchanges now have competition. They have it from foreign exchanges; they have it from over-the-counter markets. You say well, if they have that competition, then you just regulate the others to meet the same degree of regulation of our domestic exchanges.

Nor is it that simple, because of the screen-based systems based upon technology. On the over-the-counter market, if you add regulation to them, they can flee offshore. They don't have the brick and mortar that keeps them in Chicago or keeps them in New York. They could easily go outside the channels of U.S. regulation.

So we've got our domestic exchanges that have direct competition of financial markets or contracts from these other sources. The way I'm tending to look at it is that you look at 15 percent of their business are ag markets; 85 percent of their financial are financial or other markets. You don't have to look at it very long to see what pays the bills at the exchange. You know, it's other than ag markets, not to say that ag markets aren't extremely important; they are. But when 85 percent of your business is paying the bills and keeping the lights on and keeping the doors open, you've got to pay a lot of attention to that.

So I think the over-the-counter markets addressed through the President's Working Group are trying to address that situation. How can we level the playing field, make sure that our domestic exchanges have the ability to compete so basically they can keep the doors open to foster ag markets that we currently have?

So it's, I think, a very difficult question to answer and one that we have to look way beyond just the ag markets. We have to look at all the other markets, how they fit together and then how that, in turn, impacts us.

COMMISSIONER SPEARS: Well, certainly this is a big-picture issue and an issue that we'll give a lot of thought and direction as we move forward into the reauthorization process.

What I want to do is basically be able to put this on the agenda for purposes of briefing the committee members on what the report said. I would encourage all of you who received a copy of the report several weeks ago after it was finalized and sent to the Hill to read through the report in your spare time. It is fairly lengthy but does contain a lot of information.

And I would ask that you would, as Neal did, make your own assessment of what the report says and then, if you have any viewpoints, feel free to share that with the Commission. Again I'm sure the Hill would also be very much interested in hearing what your thoughts might be on the issue, as well.

Ken.

MR. ACKERMAN: Just a quick clarification. Bob, I appreciate your walk-through of it.

On the electronic trading provisions, do I understand it correctly that the exclusion would only apply to electronic trading systems that were limited to swaps trading that was subject to the swaps exclusion or does it go beyond that? In other words, trades in swaps by approved swaps traders on nonfinancial commodities with finite supplies and all those elements of the swaps exclusion, would they apply to the el

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Commodity Futures Trading Commission Agricultural Advisory Committee 27th MEETING

1:00 p.m. Wednesday, December 8, 1999

Commodity Futures Trading Commission
Agricultural Advisory Committee
27th MEETING

1:00 p.m.
Wednesday, December 8, 1999